Chapter 7

Leverage and Capital Structure

Leverage – portion of a business’s fixed cost - Usually lower than break-even point
that represents a risk to the firm = fixed cost MINUS non-cash
 Operating Leverage – measure of charges
operating risk = (fixed cost MINUS depreciation)
- Fixed operating costs found in the DIVIDED BY unit CM
income statement B. Operating Leverage – measure of
 Financial Leverage – measure of operating risk
financial risk - Arises from the business’s use of fixed
- Long term financing with fixed operating cost
financing charges of business’s - Simple indication = impact of a change
assets in sales on earning before interest and
- Higher financial leverage = higher taxes (EBIT)
financial risk and higher cost of - Operating Leverage at a given
capital Level of Sales (x) = percent change in
* Optimal structure for any business enterprise *EBIT DIVIDED BY percent change in
depends to a great extent on the amount of sales
leverage the business can tolerate and the ( p−v ) x
resultant cost of capital =
( p−v ) x−FC
- *EBIT = (p-v) x - FC
S – Sales C. Financial Leverage – measure of financial
x – Sales Volume per Unit risk
p – Selling Price per Unit - Arises from the presence of debt and/or
v – Unit Variable Cost preference share capital in business’s
VC – Variable Operating Cost capital structure
FC – Fixed Operating Cost - way to measure: determine how earning
per share (EPS) are affected by a change
A. Break-even Analysis – closely related to in EBIT
operating leverage - If EBIT falls = financially leveraged
- Determines *break-even sales business will experience negative
[*financial crossover point at which changes in EPS that are larger than
revenue exactly match costs] relative decline in EBIT
- Important Concepts - Preference share divided must be
 Contribution Margin (CM) – adjusted for tax
amount of money available to cover - Financial Leverage at a given Level
fixed cost (FC) and generate profits of Sales (x) = percent change in EPS
- excess of sales (S) over the DIVIDED BY percent change in EBIT
variable cost (VC) ( p−v ) x−FC
= S – VC =
( p−v ) x−FC−I
 Unit CM – excess of unit selling price
* I = fixed finance charges
(p) over the unit variable cost (v)
Total Leverage – measure of total risk
=p–v
- To measure: determine how EPS is
a. Break-Even Point – level of sales
affected by a change in sales
revenue that equals to the total of
- Total Leverage at a given Level of
variable and fixed costs for any given
Sales (x)
volume of output at a particular capacity
= percent change in EPS DIVIDED BY
use rate
percent change in sales
- Lower BEP = higher profits and less
= operating leverage MULTIPLIED BY
operating risk
financial leverage
- Break-Even Points in Units = fixed
cost DIVIDED BY unit CM ( p−v ) x ( p−v ) x −FC
= ×
b. Cash Break-Even Point – necessary ( p−v ) x−FC ( p−v ) x−FC −I
sales to cover all cash expenses during ( p−v )x
=
the period ( p−v ) x−FC −1
- Not all fixed operating cost involve
cash payment (e.g. depreciation) Tools of Capital Structure Management
* Capital Structure Management – mix of - Can be used for two types of
long-term funding source used by business comparison
- To maximize market value of business i. Can compare past and expected
- Optimal Capital Structure – mix, future ratios for the same
minimizes the overall cost of capital business in order to determine if
o Not all financial managers believe that there has been improvement or
this actually exists deterioration in coverage over
o May allow a higher portion of debt to time
equity than actual industry average = ii. To evaluate capital structure of
justify more debt than industry other businesses in the same
- Decision to use debt and/or preference industry
share in capitalization results in two types of - Common Ratios
financial leverage effect a. Time Interested Earned – most
i. Increased risk to EPS caused by the use widely used comparative ratio
of financial obligations - Reveals nothing about
ii. Relates to the level of EPS at a given business’s ability to meet
EBIT under a specific capital structure principal payments on its debt
- Tools = EBIT DIVIDED BY interest on
1. EBIT-EPS Analysis – practical tool that debt
enables financial managers to evaluate b. Debt-Service Coverage –
alternative financing plans by investing coverage ratio for full debt-service
their effect on EPS for a range of EBIT burden
levels EBIT
- Primary objective: determine the EBIT = Principal Payments
Interest 1+
break-even or indifference points at 1−Tax rate
which the EPS will be the same * Financial risk associated with leverage should
regardless of the financing plan be analyzed of the business’s ability to service
- EBIT amount > EBIT indifference level total fixed charges
= more highly leveraged financing * Lease financing is NOT a debt, but it has
plan will generate higher EPS same impact on cash flow.
- EBIT amount < EBIT indifference level
= financing plan involving least Factors that Influence Capital Structure
leverage will generate higher EPS 1. Growth rate and stability of future sales
= 2. Competitive structure in the industry
(EBIT −I )(1−t)PD ( EBIT −I )(1−t) PD 3. Asset makeup of individual firm
= 4. The business risk which the firm is exposed
S1 S2
2. Analysis of Cash Flow – to determine 5. Control status of owners and management
the ability to service fixed charges 6. Lenders’ attitudes toward the industry and
- Greater peso amount of debt and/or the business
preference share capital the business Factors that Affect the Level of Target
issues and the shorter their maturity Debt Ratio
= greater fixed charges the business Main: Business’s ability to service fixed
will have to bear financing costs
- Before assuming additional charges, Other:
business should analyze its future a. Maintaining a desired bond rating
expected future cash flows b. Providing an adequate borrowing reserve
o Inability to meet future charges = c. Exploiting the advantages of financial
leverages
insolvency
- Greater and more stable expected
future cash flow = greater debt
capacity
3. Calculation of Comparative
Coverage Ratio – corporate financial
officer typically uses as EBIT as a rough
measure of the cash flow available to
cover debt-servicing obligation