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Foundations of Finance Arthur Keown John D. Martin J. William Petty Determining the Finance Mix Chapter 12 Learning Objectives Understanding the difference between risk and financial risk. Use the technique of break-even analysis in a variety of analytical settings.

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foundations of finance arthur keown john d martin j william petty
Foundations of Finance

Arthur Keown

John D. Martin

J. William Petty

learning objectives
Learning Objectives
  • Understanding the difference between risk and financial risk.
  • Use the technique of break-even analysis in a variety of analytical settings.
  • Distinguish among the financial concepts of operating leverage, financial leverage, and combined leverage.
  • Calculate the firm’s degree of operating leverage, financial leverage, and combined leverage.
  • Understand the concept of an optimal capital structure.

Keown Martin Petty - Chapter 12

learning objectives4
Learning Objectives
  • Explain the main underpinnings of capital structure theory.
  • Understand and be able to graph the moderate position on capital structure importance.
  • Incorporate the concepts of agency costs and free cash flow into a discussion on capital structure management.
  • Use the basic tools of capital structure management.
  • Understand how business risk and global sales impact the multinational firm.

Keown Martin Petty - Chapter 12

slide contents
Slide Contents
  • Principles Used in this chapter
  • Risk
  • Break-even Analysis
  • Operating and Financial leverage
  • Planning the Financing Mix
  • Capital Structure Theory
  • Capital Structure Management (Basic Tools)
  • Capital Structure Management (Survey Results)
  • Finance and the Multinational Firm

Keown Martin Petty - Chapter 12

principles used in this chapter
Principles Used in this Chapter
  • Principle 1:
    • The Risk-Return Tradeoff – We Won’t Take on Additional Risk Unless We Expect to Be Compensated With Additional Return
  • Principle 3:
    • Cash-Not Profits-Is King
  • Principle 7:
    • The Agency Problem – Managers Won’t Work for the Owners Unless It’s in Their Best Interest
  • Principle 8:
    • Taxes Bias Business Solutions

Keown Martin Petty - Chapter 12

slide9
Risk
  • The variability associated with expected revenue or income streams. Such variability may arise due to:
    • Choice of business line (business risk).
    • Choice of an operating cost structure (operating risk).
    • Choice of capital structure (financial risk).

Keown Martin Petty - Chapter 12

business risk
Business Risk
  • Business Risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates. There are four determinants of business risk:
    • The stability of the domestic economy
    • The exposure to, and stability of, foreign economies
    • Sensitivity to the business cycle, and
    • Competitive pressures in the firm’s industry.

Keown Martin Petty - Chapter 12

operating risk
Operating Risk
  • Operating risk is the variation in the firm’s operating earnings that results from the firm’s cost structure (mix of fixed and variable operating costs).
  • Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues.

Keown Martin Petty - Chapter 12

financial risk
Financial Risk
  • Financial Risk is the variation in earnings as a result ofafirm’s financing mix or proportion of financing that requires a fixed return.

Keown Martin Petty - Chapter 12

break even analysis
Break-even Analysis
  • Break-even analysis is used to determine the break-even quantity of a firm’s output by examining the relationships among the firm’s cost structure, volume of output, and profit.
  • Break-even may be calculated in units or sales dollars. Break-even point indicates the point of sales or units at which EBIT is equal to zero.

Keown Martin Petty - Chapter 12

break even analysis15
Break-even Analysis
  • Use of break-even model enables the financial officer:
    • To determine the quantity of output that must be sold to cover all operating costs, as distinct from financial costs.
    • To calculate the EBIT that will be achieved at various output levels.

Keown Martin Petty - Chapter 12

elements of break even model
Elements of Break-even Model
  • Break-even analysis requires information on the following:
      • Fixed Costs
      • Variable Costs
      • Total Revenue
      • Total Volume

Keown Martin Petty - Chapter 12

slide17
Break-even analysis requires classification of costs into two categories:
    • Fixed costs or indirect costs
    • Variable costs or direct costs
  • Since all costs are variable in the long-run, break-even analysis is a short-run concept.

Keown Martin Petty - Chapter 12

fixed or indirect costs
Fixed or Indirect Costs
  • These costs do not vary in total amount as sales volume or the quantity of output changes.
    • As production volume increases, fixed costs per unit of product falls, as fixed costs are spread over a larger and larger quantity of output (but total remains the same).
    • Fixed costs vary per unit but remain fixed in total.
    • The total fixed costs are generally fixed for a specific range of output.

Keown Martin Petty - Chapter 12

fixed costs
Fixed Costs

Examples:

  • Administrative salaries
  • Depreciation
  • Insurance
  • Lump sums spent on intermittent advertising programs
  • Property taxes
  • Rent

Keown Martin Petty - Chapter 12

variable or direct costs
Variable or Direct Costs
  • Variable costs vary as output changes. Thus if production is increased by 5%, total variable costs will also increase by 5%.
  • Total variable costs = VC x N
    • Where VC = Variable cost per unit
    • N = # of units produced and sold

Keown Martin Petty - Chapter 12

variable costs
Variable Costs

Examples:

  • Direct labor
  • Direct materials
  • Energy costs (fuel, electricity, natural gas) associated with the production
  • Freight costs
  • Packaging
  • Sales commissions

Keown Martin Petty - Chapter 12

revenue
Revenue
  • Total revenue is the total sales dollars
  • Total Revenue = P x Q
    • P = selling price per unit
    • Q = quantity sold

Keown Martin Petty - Chapter 12

volume
Volume
  • The volume of output refers to the firm’s level of operations and may be indicated either as a unit quantity or as sales dollars.

Keown Martin Petty - Chapter 12

break even point bep
Break-even Point (BEP)
  • BEP = Point at which EBIT equals zero
  • EBIT = (Sales price per unit) (units sold)

– [(variable cost per unit) (units sold) + (total fixed cost)]

Keown Martin Petty - Chapter 12

break even point bep26
Break-even Point (BEP)
  • BEP (Units) = Total Fixed costs

(Unit sales price – Unit variable cost)

  • BEP (dollars) = Total Fixed Costs

1 – Variable cost/sales price

Keown Martin Petty - Chapter 12

example
Example
  • Selling price per unit is $12; Variable cost per unit is $6; Fixed costs are $120,000
  • BEP (units) = $120,000/ ($12-$6)

= $120,000/$6

= 20,000 units

  • If the firm sells 20,000 units, EBIT will be equal to zero.

Keown Martin Petty - Chapter 12

example28
Example
  • BEP (in dollars)

= 120,000

1 – 12/6

= 120,000/.5

= $240,000

  • At sales of $240,000, EBIT will be equal to zero.

Keown Martin Petty - Chapter 12

bep for pierce grain company
BEP for Pierce Grain Company

Keown Martin Petty - Chapter 12

example30
Example
  • Selling price = $10 per unit
  • Variable cost = $6 per unit
  • Fixed cost = $100,000
  • BEP (Units) = Total Fixed costs

(Unit sales price – Unit variable cost)

= 100000/4 = 25000 units

Keown Martin Petty - Chapter 12

example31
Example
  • BEP (dollars) = Total Fixed Costs

1 – Variable cost/sales price

  • BEP (in $ revenues) = $100,000/.4

=$250,000

    • (1-180000/300000) = 1 - .6 = .4

Keown Martin Petty - Chapter 12

operating leverage
Operating Leverage
  • Operating leverage measures the sensitivity of the firm’s EBIT to fluctuation in sales, when a firm has fixed operating costs.
  • If the firm has no fixed operating costs, EBIT will change in proportion to the change in sales.

Keown Martin Petty - Chapter 12

operating leverage34
Operating Leverage
  • Operating Leverage (OL) = % change in EBIT

% change in sales

  • Thus % change in EBIT

= OL X % change in sales

Where :

% change in EBIT = EBITt1 – EBITt / EBITt

% Change in sales =Salest1 – Salest / Salest

Keown Martin Petty - Chapter 12

operating leverage35
Operating Leverage
  • Example:If a company has an operating leverage of 6, then what is the change in EBIT if sales increase by 5%?

Percentage change in EBIT = Operating leverage X Percentage change in sales = 5% x 6 = 30%

Thus if the firm increases sales by 5%, EBIT will increase by 30%

Keown Martin Petty - Chapter 12

operating leverage36
Operating Leverage
  • Operating leverage is present when:
    • Percentage change in EBIT / Percentage change in sales > 1.00
  • The greater the firm’s degree of operating leverage, the more the profits will vary in response to change in sales.

Keown Martin Petty - Chapter 12

operating leverage for pierce grain
Operating Leverage for Pierce Grain

Keown Martin Petty - Chapter 12

operating leverage for pierce grain38
Operating Leverage for Pierce Grain
  • Due to operating leverage, even though the sales increase by only 20%, EBIT increases by 120%. (and vice versa, if sales dropped by 20%, EBIT will fall by 120%; see next slide)
  • If Pierce had no operating leverage (i.e. all of its operating costs were variable), then the increase in EBIT would have been in proportion to increase in sales, i.e. 20%.

Keown Martin Petty - Chapter 12

financial leverage
Financial Leverage
  • Financial leverage is financing a portion of the firm’s assets with securities bearing a fixed rate of return in hopes of increasing the return to the common stockholders.
  • Thus, the decision to use preferred stock or debt exposes the common stockholders to financial risk.
  • Variability of EBIT is magnified by firm’s use of financial leverage.

Keown Martin Petty - Chapter 12

three financing plans for pierce grain
Three financing plans for Pierce Grain

Keown Martin Petty - Chapter 12

three financing plans for pierce grain42
Three financing plans for Pierce Grain
  • Plan A: 0% debt – no financial risk
  • Plan B: 25% debt – moderate financial risk
  • Plan C: 40% debt – higher financial risk
  • See next slide for impact of financial leverage on earnings per share (EPS). The use of financial leverage magnifies the impact of changes in EBIT on earnings per share.

Keown Martin Petty - Chapter 12

slide44
A firm is employing financial leverage and exposing its owners to financial risk when:
    • Percentage change in EPS divided by Percentage change in EBIT is greater than 1.00

Keown Martin Petty - Chapter 12

combined leverage
Combined Leverage
  • Operating leverage causes changes in sales revenues to cause even greater changes in EBIT; furthermore, changes in EBIT due to financial leverage create large variations in both EPS and total earnings available to common shareholders.
  • Not surprisingly, combining operating and financial leverage causes rather large variations in EPS

Keown Martin Petty - Chapter 12

combined leverage46
Combined Leverage
  • Combined Leverage = Percentage change in EPS/Percentage change in sales
  • Or combined leverage = Operating Leverage X Financial Leverage
  • See table 12-6

Keown Martin Petty - Chapter 12

combining operating and financial leverage
Combining Operating and Financial Leverage

Keown Martin Petty - Chapter 12

capital structure
Capital Structure
  • Financial Structure
    • Mix of all items that appear on the right-hand side of the company’s balance sheet
  • Capital Structure
    • Mix of the long-term sources of funds used by the firm
    • Financial Structure – Current liabilities = Capital Structure

Keown Martin Petty - Chapter 12

financial structure
Financial Structure
  • Designing a prudent financial structure requires answers to the following:

1. How should a firm best divide its total fund sources between short- and long-term components?

2. Capital structure management: In what proportions relative to the total should the various forms of permanent financing be utilized?

  • This chapter focuses on the second question.

Keown Martin Petty - Chapter 12

capital structure management
Capital Structure Management
  • A firm should mix the permanent sources of funds in a manner that will maximize the company’s stock price, or minimize the cost of capital.
  • A proper mix of funds sources is called the “optimal capital structure”.

Keown Martin Petty - Chapter 12

capital structure theory
Capital Structure Theory
  • Theory focuses on the effect of financial leverage on the overall cost of capital to the enterprise.
  • In other words, Can the firm affect its overall cost of funds, either favorably or unfavorably, by varying the mixture of financing used?
  • Firms strive to minimize the cost of using financial capital.

Keown Martin Petty - Chapter 12

m m s independence hypothesis
M&M’s Independence Hypothesis
  • According to Modigliani & Miller, neither the total value of the firm nor the cost of capital is influenced by the firm's capital structure.In other words, the financing decision is irrelevant!
  • Their conclusions were based on restrictive assumptions (such as no taxes, perfect or efficient markets).

Keown Martin Petty - Chapter 12

m m s independence hypothesis55
M&M’s Independence Hypothesis
  • Figure 12-5 that shows that firm’s value remains the same, despite the differences in financing mix.

Keown Martin Petty - Chapter 12

m m s independence hypothesis57
M&M’s Independence Hypothesis
  • Figure 12-6 shows that the firm’s cost of capital remains constant, although cost of equity rises with increased leverage.

Keown Martin Petty - Chapter 12

extensions to independence hypothesis
Extensions to Independence Hypothesis
  • How is the capital structure decision affected when we consider:
    • Tax benefit on interest expense
    • Possibility of financial distress
    • Agency cost of debt

Keown Martin Petty - Chapter 12

impact of taxes on capital structure
Impact of taxes on capital structure
  • Interest expense is tax deductible.
  • Because interest is deductible, the use of debt financing should result in higher total market value for firms outstanding securities.
  • Tax Shield benefit = rd(m)(t)

r = rate, m = principal, t = marginal tax rate

Keown Martin Petty - Chapter 12

slide61
Interest on debt is tax deductible.

==> higher the interest expense, lower the taxes

  • Thus, one would suggest that firms should maximize Debt … indeed, firms should go for 100% debt to maximize tax shield benefits!!
  • But, we generally do not see 100% debt in the real world. Why not?

Keown Martin Petty - Chapter 12

slide62
Two possible explanations are:
    • Bankruptcy costs
    • Agency costs

Keown Martin Petty - Chapter 12

impact of bankruptcy on capital structure
Impact of Bankruptcy on Capital structure
  • The Probability that a firm will be unable to meet its debt obligations increases with debt. Thus probability of bankruptcy (and hence costs) increases with increased leverage. Threat of financial distress causes the cost of debt to rise.
  • As financial conditions weaken, expected costs of default can be large enough to outweigh the tax shield benefit of debt financing.

Keown Martin Petty - Chapter 12

impact of bankruptcy on capital structure64
Impact of Bankruptcy on Capital structure
  • So higher debt does not lead to higher value. After a point debt reduces the value of the firm to shareholders.
  • This explains a tendency to restrain from maximizing the use of debt.
  • Debt capacity indicates the maximum proportion of debt the firm can include in its capital structure and still maintain its lowest composite cost of capital (see figure 12-7).

Keown Martin Petty - Chapter 12

agency costs
Agency Costs
  • To ensure that agent-managers act in shareholders best interest, firms must:

1.Have proper incentives

2. Monitor decisions

-bonding the managers

-auditing financial statements

-structuring the organization in unique ways that limit useful managerial decisions

-reviewing the costs and benefits of management perquisites

  • The costs of the incentives and monitoring must be borne by the stockholders.

Keown Martin Petty - Chapter 12

impact of agency costs on capital structure
Impact of Agency Costs on Capital Structure
  • Capital structure management also gives rise to agency costs. Bondholders are principals as essentially they have given a loan to the corporation, that is owned by shareholders.
  • Agency problems stem from conflicts of interest between stockholders and bondholders. For example, pursuing risky projects may benefit stockholders, but may not be appreciated by bondholders
  • Bondholders greatest fear is default by corporation or misuse of funds leading to financial distress.

Keown Martin Petty - Chapter 12

impact of agency costs on capital structure67
Impact of Agency Costs on Capital Structure
  • Agency costs may be minimized by agreeing to include several protective covenants in the bond contract
  • Bond covenants impose costs (such as periodic disclosure) and impose constraints (on the type of project management can undertake, Collateral, distribution of dividends, and limits on further borrowing)
  • Thus agency costs of debt reduces the attractiveness of debt and decreases the value of the firm.

Keown Martin Petty - Chapter 12

slide68
Figure 12-8 indicates the trade-offs. For example, increasing the protective covenants will reduce the interest cost but increase the monitoring cost (which is eventually borne by the shareholders).

Keown Martin Petty - Chapter 12

summary of capital structure theory
Summary of Capital Structure Theory
  • Market value of levered firm

= Market value of unlevered firm

+ Present value of tax shields

- Present value of Financial distress costs

- Present value of agency costs

Keown Martin Petty - Chapter 12

two tools
Two tools
  • Two basic tools used to evaluate capital structure decisions:
    • EPS-EBIT Chart
    • Financial leverage ratios

Keown Martin Petty - Chapter 12

eps ebit chart
EPS-EBIT Chart
  • Managers care about EPS as it sends an important signal to the market about future prospects and will affect the stock prices.
  • The EPS-EBIT chart provides a way to visualize the effects of alternative capital structure on both the level and volatility of the firm’s earning per share (EPS).

Keown Martin Petty - Chapter 12

figure 12 10
Figure 12-10
  • The chart shows that at a specific level of EBIT, stock and bond plan produce different EPS (except at the intersection point with EBIT =$21,000 where EPS is equal to $4.25 under both plans).
  • Above the intersection point, EPS will be higher for plan with greater leverage (and vice versa).
  • For example, at EBIT of $30,000
    • EPS using bond plan = $7.25
    • EPS using stock plan = $6.50

Keown Martin Petty - Chapter 12

finding the intersection point
Finding the Intersection point
  • Compare EPS-stock plan versus EPS-bond plan and solve for EBIT in the following two equations:
  • (EBIT-I)(1-t)-P = (EBIT-I)(1-t)-P

Ss Sb

Ss = # of stocks under stock plan

Sb = # of stocks under bond plan

I = interest expense

P = preferred stock

Keown Martin Petty - Chapter 12

slide77
EPS-EBIT chart is simply a tool to analyze capital structure decision.
  • Thus achieving a high EPS based on high leverage may not be the right decision.
  • The final decision will be made after weighing all factors.

Keown Martin Petty - Chapter 12

leverage ratios
Leverage Ratios
  • Two ratios (as covered in chapter 4), balance sheet leverage ratio and coverage ratio, can be computed and compared to industry norms.
  • If the ratios are significantly different from industry average, the managers must have a sound reason.

Keown Martin Petty - Chapter 12

the ten factors
The Ten Factors
  • A survey of 392 corporate executives reveals the following ten factors as important determinants of capital structure decision:
    • Financial flexibility:
      • Firm’s bargaining position is better if it has choices
    • Credit Rating:
      • Downgrading of credit rating will increase borrowing costs and thus managers try to avoid anything that will trigger credit downgrades

Keown Martin Petty - Chapter 12

the ten factors81
The Ten Factors
  • Insufficient internal funds:
    • Firms follow a pecking order for raising funds – internal funds followed by debt and then equity.
  • Level of interest rates:
    • Firms tend to borrow when interest rates are low relative to their expectations
  • Interest tax savings

Keown Martin Petty - Chapter 12

the ten factors82
The Ten Factors
  • Transaction costs and fees:
    • Cost of issuing equity is relatively higher than debt, making equity a less attractive source.
  • Equity valuation:
    • If shares are undervalued, firms will like to issue debt, and vice versa.
  • Competitor:
    • Firms from similar businesses tend to have similar capital structures.

Keown Martin Petty - Chapter 12

the ten factors83
The Ten Factors
  • Bankruptcy/distress costs:
    • Higher existing debt will increase the likelihood of financial distress.
  • Customer/supplier discomfort:
    • High levels of debt will increase discomfort among customers (fearing disruption in supply) and suppliers (fearing disruption in demand and late/non payment on existing contracts).

Keown Martin Petty - Chapter 12

finance and the multinational firm business risk and global sales
Finance and the Multinational Firm: Business Risk and Global Sales
  • Business risk is both multidimensional and international, and is affected by:
    • The sensitivity of the firm’s product demand to general economic conditions
    • The degree of competition to which the firm is exposed
    • Product diversification
    • Growth prospects, and
    • Global sales volumes and production output.

Keown Martin Petty - Chapter 12