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Copyright 2012 Pearson Prentice Hall. All rights reserved.Chapter 12Leverage and Capital Structure1 2012 Pearson Prentice Hall. All rights reserved.12-2ObjectivesDiscuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect of changing costs on the breakeven point.Understand operating, financial, and total leverage and the relationships among them.Describe the types of capital and the external assessment of capital structure. 2012 Pearson Prentice Hall. All rights reserved.12-3LeverageLeverage refers to the effects that fixed costs have on the returns that shareholders earn; higher leverage generally results in higher, but more volatile returns.Fixed costs are costs that do not rise and fall with changes in a firms sales volume. Firms have to pay these fixed costs whether business conditions are good or bad.Generally, leverage magnifies both returns and risks.Capital structure is the mix of long-term debt and equity maintained by the firm.

2012 Pearson Prentice Hall. All rights reserved.12-4Leverage (cont.)Operating leverage is concerned with the relationship between the firms sales revenue and its earnings before interest and taxes (EBIT) or operating profits. Financial leverage is concerned with the relationship between the firms EBIT and its common stock earnings per share (EPS)Total leverage is the combined effect of operating and financial leverage. It is concerned with the relationship between the firms sales revenue and EPS.

2012 Pearson Prentice Hall. All rights reserved.12-5General Income Statement Format and Types of Leverage

Impact of Operating Leverage on ProfitsBefore: Firm AFirm BFirm CSales $ 10,000 $ 11,000 $ 19,500 Operating Costs: Fixed (FC)7000200014000 Variable (VC)200070003000Operating Profit (EBIT) $ 1,000 $ 2,000 $ 2,500 2012 Pearson Prentice Hall. All rights reserved.12-7After: (50% Increase)Firm AFirm BFirm CSales $ 15,000 $ 16,500 $ 29,250 Operating Costs: Fixed (FC)7000200014000 Variable (VC)3000105004500Operating Profit (EBIT) $ 5,000 $ 4,000 $ 10,750 2012 Pearson Prentice Hall. All rights reserved.12-8Leverage: Breakeven AnalysisBreakeven analysis is used to indicate the level of operations necessary to cover all costs and to evaluate the profitability associated with various levels of sales; also called cost-volume-profit analysis.The operating breakeven point is the level of sales necessary to cover all operating costs; the point at which EBIT = $0.The first step in finding the operating breakeven point is to divide the cost of goods sold and operating expenses into fixed or variable operating costs. Fixed costs are costs that the firm must pay in a given period regardless of the sales volume achieved during that period. Variable costs vary directly with sales volume. 2012 Pearson Prentice Hall. All rights reserved.12-9Leverage: Breakeven AnalysisUsing an algebraic calculation as a formula for earnings before interest and taxes yields:EBIT = (P Q) (VC Q) FC Simplifying yields:EBIT = Q (P VC) FCSetting EBIT equal to $0 and solving for Q (the firms breakeven point) yields:

2012 Pearson Prentice Hall. All rights reserved.12-10Leverage: Breakeven Analysis (cont.)Assume that Cheryls Posters, a small poster retailer, has fixed operating costs of $2,500. Its sale price is $10 per poster, and its variable operating cost is $5 per poster. What is the firms breakeven point?

2012 Pearson Prentice Hall. All rights reserved.12-11Leverage: Breakeven Analysis (cont.)Assume that Cheryls Posters wishes to evaluate the impact of several options: (1) increasing fixed operating costs to $3,000, (2) increasing the sale price per unit to $12.50, (3) increasing the variable operating cost per unit to $7.50, and (4) simultaneously implementing all three of these changes. Operating breakeven point = $3,000/($10 $5) = 600 units

Operating breakeven point = $2,500/($12.50 $5) = 333 units

Operating breakeven point = $2,500/($10 $7.50) = 1,000 units

Operating breakeven point = $3,000/($12.50 $7.50) = 600 units

2012 Pearson Prentice Hall. All rights reserved.12-12Break Even of Dollar Sales 2012 Pearson Prentice Hall. All rights reserved.12-13 2012 Pearson Prentice Hall. All rights reserved.12-14Leverage: Operating Leverage (cont.)The degree of operating leverage (DOL) is the numerical measure of the firms operating leverage.

As long as DOL is greater than 1, there is operating leverage.

2012 Pearson Prentice Hall. All rights reserved.12-15

2012 Pearson Prentice Hall. All rights reserved.12-16Leverage: Operating Leverage (cont.)A more direct formula for calculating the degree of operating leverage at a base sales level, Q, is the following:

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500 into the above equation yields the following result:

2012 Pearson Prentice Hall. All rights reserved.12-17Leverage: Operating Leverage (cont.)Assume that Cheryls Posters exchanges a portion of its variable operating costs for fixed operating costs by eliminating sales commissions and increasing sales salaries. This exchange results in a reduction in the variable operating cost per unit from $5 to $4.50 and an increase in the fixed operating costs from $2,500 to $3,000.

2012 Pearson Prentice Hall. All rights reserved.12-18End to DOL