Upload
pranajaya2010
View
224
Download
0
Embed Size (px)
Citation preview
8/14/2019 Ch 14 Capital Structure Management
1/18
Copyright 2003 South-Western/Thomson Learning
Chapter 14Capital Structure Management
in Practice
8/14/2019 Ch 14 Capital Structure Management
2/18
Introduction
This chapter focuses on the impact ofleverage on corporate profits. We willcover:
Operating and financial leverage (pp.472-475)
Breakeven analysis (Appendix 14A)
EBIT-EPS analysis (pp. 482-493)
8/14/2019 Ch 14 Capital Structure Management
3/18
Operating and Financial Leverage
Based on fixed operatingand/or fixedcapital costs:
Fixed operating costsassets added to
grow the firm Depreciation of PP&E
Rent and utility costs
Property taxes
Salaried costs
Fixed capital costfunds the assets
Interest charges
Preferred dividends
8/14/2019 Ch 14 Capital Structure Management
4/18
Operating and Financial Leverage
Operating Leverage Results from fixed operating costs such that a
change in sales revenue is magnified into arelatively large change in EBIT
Financial Leverage Results from fixed capital costs such that achange in EBIT is magnified into a relativelylarge change in EPS
Benefits of leverage occur only withinspecific range of volumes until the firmneeds to commit additional fixed operatingor capital costs
See Table 14.2, p.475
8/14/2019 Ch 14 Capital Structure Management
5/18
Breakeven Analysis (Appendix 14A,p. 505)
Also called cost-volume-profitanalysis
Describes relationship among firms
sales, fixed cost (FC), variable costs(VC), and EBIT/EPS at various unitoutput levels (Q)
Main objective: at what sales level (Q)does the firm break even?
8/14/2019 Ch 14 Capital Structure Management
6/18
Graphical Breakeven Analysis
Graph both revenue and cost in $ on yaxis versus output (Q) in units on x axis:
Graph Total Revenue (TR = Q x
Price/unit) beginning at origin
Graph Total Cost (FC + VC) beginningwith FC on y axis
Breakeven is where TR and TC crossTR = TC
See Fig. 14A.1, p. 506
8/14/2019 Ch 14 Capital Structure Management
7/18
Algebraic Breakeven Analysis
Total Revenue (TR) = Total Cost (TC) TR = VC + FC
TR = VC/unit x units + FC
Sales/unit x units = VC/unit x units + FC Sales/unit x unitsVC/unit x units = FC
(Sales/unitVC/unit) units = FC
Note: Sales/unitVC/unit = Price-VC/unit =contribution margin ( econ. profit)/unit
Therefore:
B.E units (Q) = FC/contrib. margin/unit
8/14/2019 Ch 14 Capital Structure Management
8/18
Example: Allegan Mfg. Co
FC = $1 mils, Price (P) = $250, VC/unit =$150
Qb= $1 mils/$250$150 = 10,000units
Incr. P by $25Qb = $ 1 mils/$275 - $150 = 8000units
Spend CapEx of $1 mils ($100,000/yr in
depreciation) to reduce VC/unit by $25Qb= $1.1 mils/$250 - $125 = 8800units
Ex: pp. 507-509 (same example in detail)
8/14/2019 Ch 14 Capital Structure Management
9/18
Other Applications
1. Analyzing effects of other variables, e.g.,price (prior slide)
2. Breakeven in terms of $ sales (p. 507)Sb = FC/ 1- (VC/P)
3. Breakeven in terms of EBT or EPS (add Int.to FC = fixed charges)
4. Target Volume (p. 507)Qt= (FC + Target Profit)/Contribution
Margin/unit5. Cash breakeven (p. 512-513)
Qc= (FCDepr.)/Contri. Margin/unitNote: Useful for homework #7
8/14/2019 Ch 14 Capital Structure Management
10/18
Use EBIT-EPS analysis for determiningdebt versus equity financing for individualprojects
But, should maintain target capital structure
Steps Develop economic/profit scenarios Begin with Earnings before Interest and Taxes
(EBIT) and calculate Earnings Per Share (EPS)for both alternatives
Best alternative has highest earnings per share Other considerations: flexibility, dilution of
ownership/earnings, use of cash
See Ex, p. 482
EBIT-EPS Analysis
8/14/2019 Ch 14 Capital Structure Management
11/18
EBIT-EPS Analysis Breakeven
More accurate method of determining when tooffer equity or debtcalculate indifferencepoint
Determine the level of EBIT where EPS wouldbe identical under either debt or equityfinancing: EPS (debt fin.)=EPS (equity fin.), or
Debt financing Equity financing
=Ne
(EBITIe) (1T)Dp
Nd
(EBITId) (1 - T)Dp
See Ex. p. 484
8/14/2019 Ch 14 Capital Structure Management
12/18
Graphical Analysis of EBIT - EPS
EPS
EBIT
Debt Financing
Equity Financing
Indifference Point
Advantage to debtfinancing
Advantage toequity financing
8/14/2019 Ch 14 Capital Structure Management
13/18
Analyze the Riskiness of theCapital Structure For Expansion
1. Compute the expected level of EBIT after expansion.
2. Estimate the variability of operating income (Stnd.
Dev.).
3. Compute the indifference point between two financinplans.
4. Estimate the probability that EBIT will exceed the
indifference point (calc. z and use Table V).
5. Examine the market evidence to see if the capitalstructure is too risky in relation to the firms level of
Business risk Industry norms for leverage and coverage ratios Recommendation of the firms investment bankers
Ex:, pp. 485-486
8/14/2019 Ch 14 Capital Structure Management
14/18
Warning!
Remember, financial leverage is adouble-edged sword; it enhancesexpected returns but also increases risk
Even if EPS is higher with debt financing,high leverage could result in lower PE,
and lower stock price (bottom p. 486)
Lesson: the market will say whetherborrowing is too risky
8/14/2019 Ch 14 Capital Structure Management
15/18
Cash Insolvency Analysis (p. 487)
Helps managers choose their capital structureduring a recession when liquidity is importantCBR= CB0+ FCFR
CB0= cash at beginning of period,
FCFR= free cash flows during recession, andCBR= cash balance during recession (you wanit to be positive)
Firms needs cash (or access to cash) to surviva recession
Therefore, make CB0large enough or have
guaranteed access to bank credit and othersources of cash, e.g., auto company
C id d i C i l
8/14/2019 Ch 14 Capital Structure Management
16/18
Factors Considered in CapitalStructure Decisions
Tendency to cluster around industryaverage
Need for funds
Benchmark leverage ratios
By lenders and bond rating agencies
Managerial risk aversion
Retain control
8/14/2019 Ch 14 Capital Structure Management
17/18
8/14/2019 Ch 14 Capital Structure Management
18/18
Homework Problems
In this order: Ch 14: # 20, 14A: # 1 Assignment # 7: For Ford Automotive calculate
the following:
1. Break-even units for EBIT
2. Break-even units for EBT
3. Graph TR and TC vs units showing #2
4. Units required to earn targeted EBT of $5 bils
5. Your realistic plan for #4 involving volume,cost and/or price changes (see Allegan Mfg.)
Next Class: Chapters 16 & 19