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Chapter 12 – The Financing Mix. Key Sections: Business and Financial Risk Operating, financial and combined leverage Capital structure and financial structure Saucer-shaped cost of capital curve Management practices. Risk. Variability in revenue or income streams

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chapter 12 the financing mix
Chapter 12 – The Financing Mix
  • Key Sections:
  • Business and Financial Risk
  • Operating, financial and combined leverage
  • Capital structure and financial structure
  • Saucer-shaped cost of capital curve
  • Management practices
slide2
Risk
  • Variability in revenue or income streams
  • Business risk affects EBIT
    • Results from investment decisions (cost structure, competition, price elasticity, etc)
  • Financial risk – use of fixed rate financing sources
  • Variation in net income is due to both business and financial risk
sources of risk
Sources of Risk
  • Risk results from the presence of fixed costs
    • Fixed operating and financing costs
    • If present, what happens to EBIT and EPS if sales change?
    • EBIT will change more than sales change with fixed operating costs
    • Changes in EPS will be even greater than the change in EBIT if fixed-rate financing used
breakeven analysis
Breakeven Analysis
  • Find amount of sales to produce EBIT of zero
    • Variable or direct costs vary as output changes but are fixed per unit
    • Example: raw material costs
  • Fixed costs do not vary as sales change
    • Example: depreciation
  • Semi variable (over a range of output)
contribution margin
Contribution Margin

Per unit sales price $12

Variable cost per unit -7

Unit contribution margin 5

  • Unit sales price less unit variable cost equals contribution margin (left over to cover fixed costs)
percentage change
Percentage Change
  • Percentage change = New Value less Old

OldValue

  • Increase from 100 to 200 = 100% increase

(200 – 100) / 100 = 100%

  • Decrease from 200 to 100 = 50% decrease

(100 - 200) / 200 = -.5 = -50%

leverage
Leverage
  • In finance – presence of fixed operating costs and/or fixed financing costs cause sale changes to have a magnified impact on EBIT and EPS
  • Degree of Operating Leverage (DOL) =
  • % change in EBIT divided by sales change
    • Pierce +120% in EBIT/ +20% sales = 6 times
degree of operating leverage
Degree of Operating Leverage

2003 2004

  • Sales 300 360 +20%
  • Less: Variable Costs -180-216
  • Revenue before fixed 120 144
  • Less: Fixed -100 -100
  • EBIT 20 44 120%
  • DOL = %Δ EBIT = 120% = 6 times

%Δ Sales 20%

implications of dol
Implications of DOL
  • With DOL of 6 times, if sales increase 20%, EBIT will change by 120% (because the fixed costs don’t change)
  • If sales fall 20% EBIT will decline 120% resulting in a $4,000 operating loss
  • DOL falls as sales increase because fixed costs are spread over more units
financial leverage
Financial Leverage
  • Financing a portion of the assets with fixed-rate financing (bonds, preferred stock)
  • Degree of Financial Leverage = % change in EPS/ % change in EBIT, say 1.25 times
  • Shows responsiveness of EPS to changes in EBIT
  • Can have positive or negative effects but with greater leverage, greater changes occur
degree of financial leverage dfl
Degree of Financial Leverage DFL

20032004

EBIT 20 44 +120%

Less: Interest -4-4

Before tax 16 40

Tax @ 50% -8-20

Net Income 8 20 +150%

DFL = %Δ Net Inc = 150% = 1.25 times

%Δ EBIT 120%

combined leverage
Combined Leverage
  • With operating leverage, changes in revenue cause greater changes in EBIT. With financial leverage, EBIT changes result in greater EPS changes
  • Combining these: sales change magnifies EPS change
  • DCL = % change in EPS/ % change in Sales
  • And DCL = DOL multiplied by DFL
combined leverage13
Combined Leverage

2003 2004

Sales 300 360 +20%

Net Income 8 20 +150%

DCL = %Δ Net Inc. = 150% = 7.50 times

%Δ Sales 20

Also = DOL * DFL = 6 X * 1.25X = 7.50 X

implications
Implications
  • Total risk can be managed by combining DOL and DFL in differing degrees
  • If have high DOL (fixed costs) it may be appropriate to use lower DFL
  • If have low fixed operating costs, can tolerate more financial risk to increase returns
planning the financing mix
Planning the Financing Mix
  • Financial structure – all items on right side
  • Capital structure – all long-term sources
    • Questions: short/long mix, how much from each?
  • Maturity – influenced by nature of assets

Long-term assets + permanent part of working

capital require long-term financing

  • Objective – minimize composite cost
capital structure theory
Capital Structure Theory
  • Can we affect cost by changing mix?
  • Independence (Modigliani) – “no”
    • But assumptions may be unrealistic
  • Moderate view – more realistic
    • Considers taxes and bankruptcy risk
  • Debt encouraged by tax shield
    • Causes C of C to fall but only to a point
optimal capital structure
Optimal Capital Structure
  • Where Cost of Capital is minimized
    • Also called debt capacity – point where costs begin to increase
    • More debt, likelihood of failure increases
    • At a point, default risk outweighs tax shield
  • Cost curve – declines with added debt

Minimum cost points = optimal structure

saucer shaped curve moderate
Saucer-Shaped Curve (Moderate)
  • Before bankruptcy costs become detrimental, the tax shield causes share price to increase/ cost of capital to fall
  • Need to find the optimal range of leverage
  • Use caution in using fixed-charge capital, especially if there is operating leverage.
summary of financial leverage
Summary of Financial Leverage
  • Added variability in EPS
    • More leverage causes large changes (favorable and unfavorable) in EPS for a given EBIT change.
  • EBIT, EPS and Capital Structure
    • Above some EBIT level, EPS will be higher with leverage but there is a debt limit
management practices
Management Practices
  • Management sets debt targets based on evaluation of business risk (sales and EBIT variability). Influenced by
    • Desired bond rating
    • Having a borrowing reserve
    • Advantage of leverage
  • Unwise to use large amounts of leverage with an uncertain income stream.