chapter 11 and 14
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CHAPTER 11 and 14. LEVERAGE AND CAPITAL STRUCTURE. Business Risk and Financial Risk. Risk – the likely variability associated with expected revenue streams. The variations in the income stream can be attributed to: The firm’s exposure to business risk - PowerPoint PPT PresentationTRANSCRIPT
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LEVERAGE AND CAPITAL STRUCTURE
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• Risk – the likely variability associated with expected revenue streams.
• The variations in the income stream can be attributed to:
a. The firm’s exposure to business riskb. The firm’s decision to incur financial risk
• Business Risk – the risk that comes from the nature of the firm’s operating activities.
• Financial Risk – the risk that comes from the financial policy (i.e capital structure) of the firm.
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• Financial Leverage – the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs.
• Operating Leverage – the incurrence of fixed operating costs in the firm’s income stream.
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• Objective – to determine the break-even quantity of output by studying the relationships among the firm’s cost structure, volume of output, and operating profit. • The break-even quantity of output results in an EBIT
level = 0• Some actual and potential applications of BEP include:
a. Capital expenditure analysis as a complementary technique to discounted cash flow evaluation models.
b. Pricing policyc. Labor contract negotiationsd. Evaluation of cost structuree. Financial decision making
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• Essential elements of the break-even model:1. Fixed cost – cost that do not vary in total amount as the sales
volume or the quantity of output changes. Examples:a. Administrative salariesb. Depreciationc. Insurance premiumsd. Property taxese. Rent
2. Variable cost – cost that tend to vary in total as output changes. VC are fixed per unit of output. Examples:
a. Direct materialsb. Direct Laborc. Energy cost associated with productiond. Packaginge. Freight-outf. Sales commissions
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3. Semivariables costs (Semifixed cost) – cost that exhibit the joint characteristics of both FC and VC over different ranges of output. Examples: Salaries paid to production supervisors.
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• The break-even is just a simple adaptation of the firm’s income statement expressed as:– Profit (π) = Sales – (Total VC + Total FC)
• 3 ways to find BEP:a. Trial and Error
1) Select an arbitrary output level
2) Calculate the corresponding EBIT amount
3) When EBIT = 0, BEP has been found.
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b. Contribution Margin Analysis1) Contribution Margin = Unit Selling Price – Unit VC2) BEP (units) = FC
contribution margin per unit
c. Algebraic Analysis1) QB = the break-even level of units
soldP = the unit sales priceF = the total FC for the periodV = unit VC
2) Then, QB = F
P – V 8SITI AISHAH BINTI KASSIM (FM2)
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Example:
Mutiara Corporation (MC) manufactures a complete line of women’s dress. It sells each dress for RM 30. The variable cost for this dress is 70% of sales. Mutiara Corporation; incurs fixed costs of RM 360,000, how many dress must MC sell to breakeven?
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Solutions:
*unit variable cost (VC) = 70% x RM 30 = RM 21
QB = F
P – V
= RM 360 000 = 40 000 unit
RM 30 – RM 21
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• The BEP in sales dollars:– S* = F
1 – VC
S
Example: Sales $ 300 000
(-) Total VC 180 000
Revenue before FC 120 000
(-) Total FC 100 000
EBIT $ 20 000
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Solutions:
S* = F = $ 100 0001 – VC 1 – $ 180 000
S $ 300 000
= $ 100 000
1 – 0.60
= $ 250 000
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• Degree of Operating Leverage from the base = % change in EBIT sales level (DOLs) % change in Sales
• DOLs = Q (P – V) Q (P – V) – F
• DOLs = revenue before FC = S – VC EBIT S – VC – F
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Example:Avitar Corporation manufactures a line of computer memory expansion boards used in microcomputers. The average selling price of its finished product is $175 per unit. The variable cost for these same units is $115. Avitar incurs fixed costs of $650,000 per year. Avitar estimates the sales in next year will be 20,000 units. What is Avitar expected degree of operating leverage?
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Solutions:
DOLs = Q (P – V)
Q (P – V) – F
= 20 000 ($ 175 – $ 115)
[20 000 ($ 175 – $ 115)] – $ 650 000
= 2.1818 times15SITI AISHAH BINTI KASSIM (FM2)
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• DFL = % change in EPS > 1
% change in EBIT
• DFLEBIT = EBIT
EBIT – I
* I = interest expense
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Example:Sales $ 600,000
(-) total VC $ 200,000Revenue before FC $ 400,000
(-) total FC $ 200,000EBIT $ 200,000
(-) interest expenses $ 50,000EBT $ 150,000Taxes (34%) $ 51,000Net Income (EAT) $ 99,000
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Solutions:What is the degree of financial leverage?
DFLEBIT = EBIT EBIT – I
= $ 200 000 $ 200 000 – $ 50 000
= 1.33 times
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• DCL = % change in EPS
% change in Sales
• DCLs = (DOLs) x (DFLEBIT)
• DCLs = Q (P – V)
Q (P – V) – F – I
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• Financial Structure – the mix of all funds source that appear on the right side of the balance sheet.
• Capital Structure – the mix of long term sources of funds used by the firm. Basically, this concept omits short-term liabilities.
• Financial Structure Design – the management activity of seeking the proper mix of all financing components in order to minimize the cost of raising a given of funds.
• Optimal Capital Structure – the unique capital structure that minimizes the firm’s composite cost of long term capital.
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1. EBIT-EPS indifference point – the level of EBIT that will equate EPS between two difference financing plans.
EPS: Stock Plan EPS: Bond Plan
(EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P
Ss Sb
* EBIT = earning before interest and taxes
I = interest expenses
t = firm income tax rate
P = preferred dividend paid
Ss = the number of common s/o under the stock plan
Sb = the number of common s/o under the bond plan
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2. Projected Income StatementAlternative 1 Alternative 2
EBIT XXXXXX XXXXXX (-) Interest XXXXX XXXXX
EBT XXXXXX XXXXXX (-) Taxes XXXXX XXXXX
Net Income XXXXXX XXXXXXShares XXXXXXX XXXXXXXEPS* XXX XXX
*EPS = Net Income Shares Outstanding
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Example:ING Berhad is financed entirely with 800,000 shares of common stock priced at RM 5 per unit and RM 1,000,000 worth of debt (8% 10 years bond). The company plans to raise an additional RM 2,000,000 to finance new project and considering two alternatives;
Alternative 1: 200,000 new common shares sold to the public
Alternative 2: Issue 10% bond
Projected level of EBIT is at approximately RM 2,000,000. Corporate tax rate is 28%.
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Solutions:i. Calculate the indifference level of EBIT between two
alternatives.
* Plan Stock (alternative 1)
= Interest on bond = (1,000,000 x 8% = RM 80,000)
Unit shares = 800,000 + 200,000 = 1,000,000
*Plan Bond (alternative 2)
= Interest on bond = RM 80,000 + (RM 2,000,000 x 10% = RM 280,000)
Unit shares = 800,000
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Plan Stock Plan Bond
(EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P
Ss Sb
(EBIT – 80,000) (1 – 0.28) – 0 = (EBIT – 280,000) (1 – 0.28) - 0
1,000,000 800,000
0.72 EBIT – RM 57,600 = 0.72 EBIT – RM 201,600
1,000,000 800,000
576,000 EBIT – RM 46,080,000,000 = 720,000 EBIT – RM 201,600,000,000
– 144,000 EBIT = – RM 155,520,000,000
EBIT = RM 1,080,000
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ii. Prepare the projected income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in question (i)
Alternative 1 Alternative 2
EBIT RM 1,080,000 RM 1,080,000
(-) Interest 80,000 280,000
EBT 1,000,000 800,000
(-) Taxes (28%) 280,000 224,000
Net Income 720,000 576,000
Shares 1,000,000 800,000
EPS* 0.72 0.72
*EPS = Net Income
Shares Outstanding
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iii. Which plan will provide the highest EPS for the EBIT projected level?
Alternative 1 Alternative 2
EBIT RM 2,000,000 RM 2,000,000
(-) Interest 80,000 280,000
EBT 1,920,000 1,720,000
(-) Taxes (28%) 537,600 481,600
Net Income 1,382,400 1,238,400
Shares 1,000,000 800,000
EPS* 1.3824 1.548
*EPS = Net Income
Shares Outstanding
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