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- 1. GlobAl edITIon • Principles of Managerial Finance FoUrTeenTh edITIon Lawrence J. Gitman • Chad J. Zutter
- 2. 558 Why This Chapter Matters to You In your professional life Accounting You need to understand how to calculate and analyze operating and financial leverage and to be familiar with the tax and earnings effects of various capital structures. informAtion SYStemS You need to understand the types of capital and what capital structure is because you will provide much of the information needed in management’s determination of the best capital structure for the firm. mAnAgement You need to understand leverage so that you can control risk and magnify returns for the firm’s owners and to understand capital structure theory so that you can make decisions about the firm’s optimal capital structure. mArketing You need to understand breakeven analysis, which you will use in pricing and product feasibility decisions. operAtionS You need to understand the impact of fixed and variable operating costs on the firm’s breakeven point and its operating leverage because these costs will have a major effect on the firm’s risk and return. In your personal life Like corporations, you routinely incur debt, using both credit cards for short-term needs and negotiated long-term loans. When you borrow over the long term, you experience the benefits and consequences of leverage. Also, the level of your outstanding debt relative to net worth is conceptually the same as a firm’s capital structure. it reflects your financial risk and affects the availability and cost of borrowing. Leverage and Capital Structure 13 Learning Goals LG 1 Discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect of changing costs on the breakeven point. LG 2 understand operating, financial, and total leverage and the relationships among them. LG 3 Describe the types of capital, external assessment of capital structure, the capital structure of non–u.S. firms, and capital structure theory. LG 4 explain the optimal capital structure using a graphical view of the firm’s cost-of-capital functions and a zero- growth valuation model. LG 5 Discuss the eBit–epS approach to capital structure. LG 6 review the return and risk of alternative capital structures, their linkage to market value, and other important considerations related to capital structure.
- 3. 559 Lowe’s Builds Leverage In April 2012, the home improvement chain Lowe’s issued $2 billion worth of bonds with maturities ranging from 5 to 30 years. The com- pany’s chief financial officer, Robert Hull, ex- plained in a conference call with investors that Lowe’s planned to use the proceeds from the bond sale, along with cash flow generated by the busi- ness, to buy back up to $4.5 billion of its own stock. That plan represented a significant shift in the firm’s capital structure (its mix of debt and eq- uity financing), a move that would put more cash in the hands of shareholders and apply more pressure on Lowe’s management to generate positive cash flow from the business to repay the debt. With more of its financing coming from debt, Lowe’s was adding financial leverage to its business, meaning that if the firm succeeded in selling its products, the returns to shareholders would be magnified. However, if Lowe’s instead experienced a decline in its business, paying back the debt might be difficult, and returns to shareholders would suffer as a result. At first, Lowe’s financial strategy appeared to have backfired, as the company reported dis- appointing revenues and profits from the spring and summer months of 2012, and its stock price fell from around $31 in April to $24.50 in early August. Helped by a recovering economy and later by Hurricane Sandy, however, Lowe’s business began to turn around. In the third quarter of 2012, Lowe’s profits surged 76 percent, and investors sent its stock price up 7 percent in a single day. In the 12 months starting August 1, 2012, Lowe’s stock price rose more than 70 percent, whereas the Standard & Poor’s 500 Stock Composite Index managed to gain a little more than 20 percent. Lowe’s experience after shifting its capital structure toward more debt illustrates the general principle that as a company relies more heavily on debt, its profits become more sensitive to underly- ing business conditions. Earnings rise rapidly in good times and fall more steeply in bad times, and stock prices react accordingly. In this chapter, we’ll uncover the factors that influence a company’s decisions about financing its operations with debt or equity. Lowe’s
- 4. 560 PART 6 Long-Term Financial Decisions 13.1 Leverage Leverage refers to the effects that fixed costs have on the returns that sharehold- ers earn. By “fixed costs,” we mean costs that do not rise and fall with changes in a firm’s sales. Firms have to pay these fixed costs whether business conditions are good or bad. These fixed costs may be operating costs, such as the costs incurred by purchasing and operating plant and equipment, or they may be financial costs, such as the fixed costs of making debt payments. We say that a firm with higher fixed costs has greater leverage. Generally, leverage magnifies both returns and risks. A firm with more leverage may earn higher returns on average than a firm with less leverage, but the returns on the more leveraged firm will also be more volatile. Many business risks are out of the control of managers, but not the risks associated with leverage. Managers can either increase or decrease leverage by adopting strategies that rely more heavily on fixed or variable costs. For exam- ple, a choice that many firms confront is whether to make their own products or to outsource manufacturing to another firm. A company that does its own manufacturing may invest billions in factories around the world. These facto- ries generate costs whether they are running or not so a firm that does its own manufacturing will tend to have higher leverage. In contrast, a company that outsources production can quickly reduce its costs when demand is low simply by not placing orders. Therefore, such a firm will generally have lower leverage compared to a firm that manufactures its own goods. Managers also influence leverage by choosing a specific capital structure, which is the mix of long-term debt and equity maintained by a firm. The more debt a firm issues, the higher are its debt repayment costs, and those costs must be paid regardless of how the firm’s products are selling. Because leverage can have such a large impact on a firm, the financial manager must understand how to measure and evaluate leverage, particularly when making capital structure decisions. Table 13.1 uses an income statement to highlight where different sources of leverage come from. LG 2 LG 1 leverage Refers to the effects that fixed costs have on the returns that shareholders earn; higher leverage generally results in higher but more volatile returns. capital structure The mix of long-term debt and equity maintained by the firm. TABLE 13.1 General Income Statement Format and Types of Leverage Operating leverage Sales revenue Less: Cost of goods sold Gross profits Less: Operating expenses Financial leverage Earnings before interest and taxes (EBIT) Less: Interest Total leverage Net profits before taxes Less: Taxes Net profits after taxes Less: Preferred stock dividends Earnings available for common stockholders Earnings per share (EPS) ¯˚˘˚˙ ¯˚˚˚˘˚˚˚˙ ¯ ˚ ˚ ˚ ˚ ˚ ˘ ˚ ˚ ˚ ˚ ˚ ˙
- 5. ChAPTER 13 Leverage and Capital Structure 561 • Operating leverage is concerned with the relationship between the firm’s sales revenue and its earnings before interest and taxes (EBIT) or operating profits. When costs of operations (such as cost of goods sold and operating expenses) are largely fixed, small changes in revenue will lead to much larger changes in EBIT. • Financial leverage is concerned with the relationship between the firm’s EBIT and its common stock earnings per share (EPS). On the income statement, you can see that the deductions taken from EBIT to get to EPS include interest, taxes, and preferred dividends. Taxes are clearly variable, rising and falling with the firm’s profits, but interest expense and preferred dividends are usu- ally fixed. When these fixed items are large (that is, when the firm has a lot of financial leverage), small changes in EBIT produce larger changes in EPS. • Total leverage is the combined effect of operating and financial leverage. It is concerned with the relationship between the firm’s sales revenue and EPS. We will examine the three types of leverage concepts in detail. First, though, we will look at breakeven analysis, which lays the foundation for leverage con- cepts by demonstrating the effects of fixed costs on the firm’s operations. BREAKEVEN ANALYSIS Firms use breakeven analysis, also called cost-volume-profit analysis, (1) to determine the level of operations necessary to cover all costs and (2) to evaluate the profitability associated with various levels of sales. The firm’s operating breakeven point is the level of sales necessary to cover all operating costs. At that point, earnings before interest and taxes (EBIT) equals $0.1 The first step in finding the operating breakeven point is to divide the cost of goods sold and operating expenses into fixed and 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. These costs are typically contractual; rent, for example, is a fixed cost. Because fixed costs do not vary with sales, we typi- cally measure them relative to time. For example, we would typically measure rent as the amount due per month. Variable costs vary directly with sales volume. Shipping costs, for example, are a variable cost.2 We typically measure variable costs in dollars per unit sold. Algebraic Approach Using the following variables, we can recast the operating portion of the firm’s income statement given in Table 13.1 into the algebraic representation shown in Table 13.2, where P = sale price per unit Q = sales quantity in units FC = fixed operating cost per period VC = variable operating cost per unit breakeven analysis 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. operating breakeven point The level of sales necessary to cover all operating costs; the point at which EBIT 5 $0. 1. Quite often, the breakeven point is calculated so that it represents the point at which all costs—both operating and financial—are covered. For now, we focus on the operating breakeven point as a way to introduce the concept of operating leverage. We will discuss financial leverage later. 2. Some costs, commonly called semifixed or semivariable, are partly fixed and partly variable. An example is sales commissions that are fixed for a certain volume of sales and then increase to higher levels for higher volumes. For convenience and clarity, we assume that all costs can be classified as either fixed or variable.
- 6. 562 PART 6 Long-Term Financial Decisions Rewriting the algebraic calculations in Table 13.2 as a formula for earnings be- fore interest and taxes yields Equation 13.1: EBIT = (P * Q) - FC - (VC * Q) (13.1) Q = FC P - VC (13.3) Operating Leverage, Costs, and Breakeven Analysis Item Algebraic representation Sales revenue (P 3 Q) Operating leverage Less: Fixed operating costs 2 FC Less: Variable operating costs 2 (VC 3 Q) Earnings before interest and taxes EBIT TABLE 13.2 Simplifying Equation 13.1 yields where Q is the firm’s operating breakeven point.3 Assume that Cheryl’s 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. Applying Equation 13.3 to these data yields Q = $2,500 $10 - $5 = $2,500 $5 = 500 units At sales of 500 units, the firm’s EBIT should just equal $0. The firm will have positive EBIT for sales greater than 500 units and negative EBIT, or a loss, for sales less than 500 units. We can confirm this conclusion by substituting values above and below 500 units, along with the other values given, into Equation 13.1. Example 13.1 ▶ 3. Because the firm is assumed to be a single-product firm, its operating breakeven point is found in terms of unit sales, Q. For multiproduct firms, the operating breakeven point is generally found in terms of dollar sales, S. We can find S by substituting the contribution margin, which is 100 percent minus total variable operating costs as a per- centage of total sales, denoted VC%, into the denominator of Equation 13.3. The result is Equation 13.3a S = FC 1 - VC, (13.3a) This multiproduct-firm breakeven point assumes that the firm’s product mix remains the same at all levels of sales. ¯ ˘ ˙ EBIT = Q * (P - VC) - FC (13.2) As noted above, the operating breakeven point is the level of sales at which all fixed and variable operating costs are covered, that is, the level at which EBIT equals $0. Setting EBIT equal to $0 and solving Equation 13.2 for Q yields MyFinancelab Solution Video
- 7. ChAPTER 13 Leverage and Capital Structure 563 Graphical Approach Figure 13.1 presents in graphical form the breakeven analysis of the data in the preceding example. The firm’s operating breakeven point is the point at which its total operating cost—the sum of its fixed and variable operating costs—equals sales revenue. At this point, EBIT equals $0. The figure shows that for sales be- low 500 units, total operating cost exceeds sales revenue, and EBIT is less than $0 (a loss). For sales above the breakeven point of 500 units, sales revenue exceeds total operating cost, and EBIT is greater than $0. Changing Costs and the Operating Breakeven Point A firm’s operating breakeven point is sensitive to a number of variables: the fixed operating cost (FC), the sale price per unit (P), and the variable operating cost per unit (VC). Refer to Equation 13.3 to see how increases or decreases in these vari- ables affect the breakeven point. The sensitivity of the breakeven sales volume (Q) to an increase in each of these variables is summarized in Table 13.3. As FIGuRE 13.1 Breakeven Analysis Graphical operating breakeven analysis Sales Revenue Total Operating Cost Operating Breakeven Point E B I T Fixed Operating Cost 500 0 1,000 1,500 2,000 2,500 3,000 Loss 12,000 10,000 8,000 6,000 4,000 2,000 Costs/Revenues ($) Sales (units) TABLE 13.3 Sensitivity of Operating Breakeven Point to Increases in Key Breakeven Variables Increase in variable Effect on operating breakeven point Fixed operating cost (FC) Increase Sale price per unit (P) Decrease Variable operating cost per unit (VC) Increase Note: Decreases in each of the variables shown would have the opposite effect on the operating breakeven point.
- 8. 564 PART 6 Long-Term Financial Decisions might be expected, an increase in cost (FC or VC) tends to increase the operating breakeven point, whereas an increase in the sale price per unit (P) decreases the operating breakeven point. Assume that Cheryl’s 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. Substituting the ap- propriate data into Equation 13.3 yields (1) Operating breakeven point = $3,000 $10 - $5 = 600 units (2) Operating breakeven point = $2,500 $12.50 - $5 = 3331 3units (3) Operating breakeven point = $2,500 $10 - $7.50 = 1,000 units (4) Operating breakeven point = $3,000 $12.50 - $7.50 = 600 units Comparing the resulting operating breakeven points to the initial value of 500 units, we can see that the cost increases (actions 1 and 3) raise the breakeven point, whereas the revenue increase (action 2) lowers the breakeven point. The combined effect of increasing all three variables (action 4) also results in an in- creased operating breakeven point. Rick Polo is considering having a new fuel-saving device in- stalled in his car. The installed cost of the device is $240 paid up front plus a monthly fee of $15. He can terminate use of the device any time without penalty. Rick estimates that the device will reduce his average monthly gas consumption by 20%, which, assuming no change in his monthly mileage, translates into a savings of about $28 per month. He is planning to keep the car for 2 more years and wishes to determine whether he should have the device in- stalled in his car. To assess the financial feasibility of purchasing the device, Rick calculates the number of months it will take for him to break even. Letting the installed cost of $240 represent the fixed cost (FC), the monthly savings of $28 represent the ben- efit (P), and the monthly fee of $15 represent the variable cost (VC), and substi- tuting these values into the breakeven point equation, Equation 13.3, we get Breakeven point (in months) = $240 , ($28 - $15) = $240 , $13 5 18.5 months Because the fuel-saving device pays itself back in 18.5 months, which is less than the 24 months that Rick is planning to continue owning the car, he should have the fuel-saving device installed in his car. Example 13.2 ▶ Personal Finance Example 13.3 ▶
- 9. ChAPTER 13 Leverage and Capital Structure 565 OPERATING LEVERAGE Operating leverage results from the existence of fixed costs that the firm must pay to operate. Using the structure presented in Table 13.2, we can define operating leverage as the use of fixed operating costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes. Using the data for Cheryl’s Posters (sale price, P = $10 per unit; variable operat- ing cost, VC = $5 per unit; fixed operating cost, FC = $2,500), Figure 13.2 presents the operating breakeven graph originally shown in Figure 13.1. The ad- ditional notations on the graph indicate that as the firm’s sales increase from 1,000 to 1,500 units (Q1 to Q2), its EBIT increases from $2,500 to $5,000 (EBIT1 to EBIT2). In other words, a 50% increase in sales (1,000 to 1,500 units) results in a 100% increase in EBIT ($2,500 to $5,000). Table 13.4 includes the data for Figure 13.2 as well as relevant data for a 500-unit sales level. We can illustrate two cases using the 1,000-unit sales level as a reference point: Case 1 A 50% increase in sales (from 1,000 to 1,500 units) results in a 100% increase in earnings before interest and taxes (from $2,500 to $5,000). Case 2 A 50% decrease in sales (from 1,000 to 500 units) results in a 100% decrease in earnings before interest and taxes (from $2,500 to $0). From the preceding example, we see that operating leverage works in both directions. When a firm has fixed operating costs, operating leverage is present. Example 13.4 ▶ operating leverage The use of fixed operating costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes. FIGuRE 13.2 Operating Leverage Breakeven analysis and operating leverage 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 500 0 1,000 1,500 2,000 2,500 3,000 Q1 Q2 Sales (units) Costs/Revenues ($) EBIT1 $2,500 EBIT2 $5,000 Loss EBIT Fixed Operating Cost Total Operating Cost Sales Revenue
- 10. 566 PART 6 Long-Term Financial Decisions An increase in sales results in a more-than-proportional increase in EBIT; a decrease in sales results in a more-than-proportional decrease in EBIT. Measuring the degree of Operating Leverage (dOL) The degree of operating leverage (DOL) is a numerical measure of the firm’s op- erating leverage. It can be derived using the equation4 TABLE 13.4 The EBIT for Various Sales Levels Case 2 Case 1 250% 150% Sales (in units) 500 1,000 1,500 Sales revenuea $5,000 $10,000 $15,000 Less: Variable operating costsb 2,500 5,000 7,500 Less: Fixed operating costs 2,500 2,500 2,500 Earnings before interest and taxes (EBIT) $ 0 $ 2,500 $ 5,000 2100% 1100% a Sales revenue = $10/unit * sales in units. b Variable operating costs = $5/unit * sales in units. 4. The degree of operating leverage also depends on the base level of sales used as a point of reference. The closer the base sales level used is to the operating breakeven point, the greater the operating leverage. Comparison of the de- gree of operating leverage of two firms is valid only when the same base level of sales is used for both firms. degree of operating leverage (DOL) The numerical measure of the firm’s operating leverage. DOL = Percentage change in EBIT Percentage change in sales (13.4) Whenever the percentage change in EBIT resulting from a given percentage change in sales is greater than the percentage change in sales, operating lever- age exists. In other words, as long as DOL is greater than 1, there is operating leverage. Applying Equation 13.4 to cases 1 and 2 in Table 13.4 yields the following results: Case 1 +100, +50, = 2.0 Case 2 -100, -50, = 2.0 These calculations show that Cheryl’s Posters’ EBIT changes twice as much (on a percentage basis) as its sales. For a given base level of sales, the higher the value resulting from applying Equation 13.4, the greater the degree of operating leverage. Example 13.5 ▶ MyFinancelab Solution Video
- 11. ChAPTER 13 Leverage and Capital Structure 567 Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500 into Equation 13.5 gives us DOL at 1,000 units = 1,000 * ($10 - $5) 1,000 * ($10 - $5) - $2,500 = $5,000 $2,500 = 2.0 As before, the DOL value of 2.0 means that at Cheryl’s Posters a change in sales volume results in an EBIT change that is twice as large in percentage terms.6 See the Focus on Practice box for a discussion of operating leverage at soft- ware maker Adobe. Example 13.6 ▶ 5. Technically, the formula for DOL given in Equation 13.5 should include absolute value signs because it is possible to get a negative DOL when the EBIT for the base sales level is negative. Because we assume that the EBIT for the base level of sales is positive, we do not use the absolute value signs. 6. When total revenue in dollars from sales—instead of unit sales—is available, the following equation, in which TR 5 total revenue in dollars at a base level of sales and TVC = total variable operating costs in dollars, can be used: DOL at base dollar sales TR = TR - TVC TR - TVC - FC This formula is especially useful for finding the DOL for multiproduct firms. It should be clear that because in the case of a single-product firm, TR = Q * P and TVC = Q * VC, substitution of these values into Equation 13.5 results in the equation given here. A more direct formula for calculating the degree of operating leverage at a base sales level, Q, is5 DOL at base sales level Q = Q * (P - VC) Q * (P - VC) - FC (13.5) Adobe Systems, one of the largest PC software company in the United States, domi- nates the graphic design, imaging, dy- namic media, and authoring-tool soft- ware markets. Website designers favor its Photoshop and Illustrator software ap- plications, and Adobe’s Acrobat soft- ware has become a standard for shar- ing documents online. Adobe’s ability to manage discre- tionary expenses helps keep its bottom line strong. Adobe has an additional ad- vantage: operating leverage, the use of fixed operating costs to magnify the ef- fect of changes in sales on earnings be- fore interest and taxes (EBIT). Adobe and its peers in the software industry incur the bulk of their costs early in a product’s life cycle, in the research and development focus on PRACTICE Adobe’s Leverage decrease in EBIT in 2009. A 22.6 per- cent increase in 2007 sales resulted in EBIT growth of 39.7 percent, but in 2009 as the economy endured a severe recession, Adobe revenues plunged 17.7 percent. The effect of operating le- verage was that EBIT declined even faster, posting a 35.3 percent drop. ▶ Summarize the pros and cons of operating leverage. and initial marketing stages. The up-front development costs are fixed, and subse- quent production costs are practically zero. The economies of scale are huge: Once a company sells enough copies to cover its fixed costs, incremental dollars go primarily to profit. As demonstrated in the following table, operating leverage magnified Adobe’s increase in EBIT in 2007, 2010, and 2012 while magnifying the Source: Adobe Systems Inc., “2009 and 2012 Annual Reports,” http://www.adobe.com/investor-relations/financial-documents.html. in practice Item FY2007 FY2008 FY2009 FY2010 FY2011 FY2012 Sales revenue (millions) $3,158 $3,580 $2,946 $3,800 $4,216 $4,404 EBIT (millions) $947 $1,089 $705 $1,000 $1,102 $1,186 (1) Percent change in sales 22.6% 13.4% –17.7% 29.0% 11.0% 4.4% (2) Percent change in EBIT 39.7% 15.0% –35.3% 41.9% 10.2% 7.6% DOL [(2) ÷ (1)] 1.8 1.1 2.0 1.4 0.9 1.7
- 12. 568 PART 6 Long-Term Financial Decisions Fixed Costs and Operating Leverage Changes in fixed operating costs affect operating leverage significantly. Firms sometimes can alter the mix of fixed and variable costs in their operations. For example, a firm could make fixed-dollar lease payments rather than pay- ments equal to a specified percentage of sales. or it could compensate sales rep- resentatives with a fixed salary and bonus rather than on a pure percent-of-sales commission basis. The effects of changes in fixed operating costs on operating leverage can best be illustrated by continuing our example. Assume that Cheryl’s Posters eliminates sales commissions and increases salaries. This exchange results in a reduction in the variable cost per unit from $5 to $4.50 and an increase in the fixed costs from $2,500 to $3,000. Table 13.5 presents an analysis like that in Table 13.4, but using the new costs. Although the EBIT of $2,500 at the 1,000-unit sales level is the same as before the shift in cost struc- ture, Table 13.5 shows that the firm has increased its operating leverage by in- creasing fixed costs and lowering variable costs. With the substitution of the appropriate values into Equation 13.5, the de- gree of operating leverage at the 1,000-unit base level of sales becomes DOL at 1,000 units = 1,000 * ($10 - $4.50) 1,000 * ($10 - $4.50) - $3,000 = $5,500 $2,500 = 2.2 Comparing this value to the DOL of 2.0 before the shift to more fixed costs makes it clear that the higher the firm’s fixed operating costs relative to variable operat- ing costs, the greater the degree of operating leverage. Under the new cost struc- ture, a 50% change in sales would lead to a 110% (50% 3 2.2) change in EBIT. FINANCIAL LEVERAGE Financial leverage results from the presence of fixed financial costs that the firm must pay. Using the framework in Table 13.1, we can define financial leverage as the use of fixed financial costs to magnify the effects of changes in earnings Example 13.7 ▶ Operating Leverage and Increased Fixed Costs Case 2 Case 1 250% 150% Sales (in units) 500 1,000 1,500 Sales revenuea $5,000 $10,000 $15,000 Less: Variable operating costsb 2,250 4,500 6,750 Less: Fixed operating costs 3,000 3,000 3,000 Earnings before interest and taxes (EBIT) 2$ 250 $ 2,500 $ 5,250 2110% 1110% a Sales revenue was calculated as indicated in Table 13.4. b Variable operating costs 5 $4.50/unit 3 sales in units. TABLE 13.5 financial leverage The use of fixed financial costs to magnify the effects of changes in earnings before interest and taxes on the firm’s earnings per share.
- 13. ChAPTER 13 Leverage and Capital Structure 569 before interest and taxes on the firm’s earnings per share. The two most com- mon fixed financial costs are (1) interest on debt and (2) preferred stock divi- dends. These charges must be paid regardless of the amount of EBIT available to pay them.7 Chen Foods, a small Asian food company, expects EBIT of $10,000 in the cur- rent year. It has a $20,000 bond with a 10% (annual) coupon rate of interest and an issue of 600 shares of $4 (annual dividend per share) preferred stock outstand- ing. It also has 1,000 shares of common stock outstanding. The annual interest on the bond issue is $2,000 (0.10 3 $20,000). The annual dividends on the pre- ferred stock are $2,400 ($4.00/share 3 600 shares). Table 13.6 presents the earn- ings per share (EPS) corresponding to levels of EBIT of $6,000, $10,000, and $14,000, assuming that the firm is in the 40% tax bracket. The table illustrates two situations: Case 1 A 40% increase in EBIT (from $10,000 to $14,000) results in a 100% increase in earnings per share (from $2.40 to $4.80). Case 2 A 40% decrease in EBIT (from $10,000 to $6,000) results in a 100% decrease in earnings per share (from $2.40 to $0). Example 13.8 ▶ 7. Although a firm’s board of directors can elect to stop paying preferred stock dividends, the firm typically cannot pay dividends on common stock until the preferred shareholders receive all the dividends that they are owed. Al- though failure to pay preferred dividends cannot force the firm into bankruptcy, it increases the common stockhold- ers’ risk because they cannot receive dividends until the claims of preferred stockholders are satisfied. TABLE 13.6 The EPS for Various EBIT Levelsa Case 2 Case 1 240% 140% EBIT $6,000 $10,000 $14,000 Less: Interest (I) 2,000 2,000 2,000 Net profits before taxes $4,000 $ 8,000 $12,000 Less: Taxes (T = 0.40) 1,600 3,200 4,800 Net profits after taxes $2,400 $ 4,800 $ 7,200 Less: Preferred stock dividends (PD) 2,400 2,400 2,400 Earnings available for common (EAC) $ 0 $ 2,400 $ 4,800 Earnings per share (EPS) $0 1,000 5 $0 $2,400 1,000 5 $2.40 $4,800 1,000 5 $4.80 2100% 1100% a As noted in Chapter 2, for accounting and tax purposes, interest is a tax-deductible expense, whereas dividends must be paid from after-tax cash flows. The effect of financial leverage is such that an increase in the firm’s EBIT results in a more-than-proportional increase in the firm’s earnings per share, whereas a decrease in the firm’s EBIT results in a more-than-proportional decrease in EPS.
- 14. 570 PART 6 Long-Term Financial Decisions Measuring the degree of Financial Leverage (dFL) The degree of financial leverage (DFL) is a numerical measure of the firm’s finan- cial leverage. Computing it is much like computing the degree of operating lever- age. One approach for obtaining the DFL is8 8. This approach is valid only when the same base level of EBIT is used to calculate and compare these values. In other words, the base level of EBIT must be held constant to compare the financial leverage associated with different levels of fixed financial costs. degree of financial leverage (DFL) The numerical measure of the firm’s financial leverage. DFL = Percentage change in EPS Percentage change in EBIT (13.6) Whenever the percentage change in EPS resulting from a given percentage change in EBIT is greater than the percentage change in EBIT, financial leverage exists. In other words, whenever DFL is greater than 1, there is financial leverage. Applying Equation 13.6 to cases 1 and 2 in Table 13.6 yields the following two cases: Case 1 +100, +40, = 2.5 Case 2 -100, -40, = 2.5 These calculations show that when Chen Foods’ EBIT changes, its EPS changes 2.5 times as fast on a percentage basis due to the firm’s financial leverage. The higher this value is, the greater the degree of financial leverage. Shanta and Ravi Shandra wish to assess the impact effect of additional long-term borrowing on their degree of financial leverage (DFL). The Shandras currently have $4,200 available after meeting all their monthly living (operating) expenses, before making monthly loan pay- ments. They currently have monthly loan payment obligations of $1,700 and are considering the purchase of a new car, which would result in a $500 per month increase (to $2,200) in their total monthly loan payments. Because a large portion of Ravi’s monthly income represents commissions, the Shandras believe that the $4,200 per month currently available for making loan pay- ments could vary by 20% above or below that amount. To assess the potential impact of the additional borrowing on their financial leverage, the Shandras calculate their DFL for both their current ($1,700) and proposed ($2,200) loan payments as shown on the next page using the currently available $4,200 as a base and a 20% change. Based on their calculations, the amount the Shandras will have available after loan payments with their current debt changes by 1.68% for every 1% change in the amount they will have available for making the loan payments. Example 13.9 ▶ Personal Finance Example 13.10 ▶
- 15. ChAPTER 13 Leverage and Capital Structure 571 This change is considerably less responsive—and therefore less risky—than the 2.10% change in the amount available after loan payments for each 1% change in the amount available for making loan payments with the proposed addi- tional $500 in monthly debt payments. Although it appears that the Shandras can afford the additional loan payments, they must decide if, given the variabil- ity of Ravi’s income, they are comfortable with the increased financial leverage and risk. A more direct formula for calculating the degree of financial leverage at a base level of EBIT is given by Equation 13.7, where the notation from Table 13.6 is used.9 Note that in the denominator the term 1/(1 2 T) converts the after-tax preferred stock dividend to a before-tax amount for consistency with the other terms in the equation. Current DFL Proposed DFL Available for making loan payments $4,200 (120%) $5,040 $4,200 (120%) $5,040 Less: Loan payments 1,700 1,700 2,200 2,200 Available after loan payments $2,500 (133.6%) $3,340 $2,000 (142%) $2,840 DFL = +33.6, +20, = 1.68 DFL = +42, +20, = 2.10 9. By using the formula for DFL in Equation 13.7, it is possible to get a negative value for the DFL if the EPS for the base level of EBIT is negative. Rather than show absolute value signs in the equation, we instead assume that the base-level EPS is positive. DFL at base level EBIT = EBIT EBIT - I - aPD * 1 1 - T b (13.7) Entering EBIT = $10,000, I = $2,000, PD = $2,400, and the tax rate (T = 0.40) from Table 6 into Equation 13.7 yields DFL at $10,000 EBIT = $10,000 $10,000 - $2,000 - a$2,400 * 1 1 - 0.40 b = $10,000 $4,000 = 2.5 Note that the formula given in Equation 13.7 provides a more direct method for calculating the degree of financial leverage than the approach illustrated using Table 13.6 and Equation 13.6. Example 13.11 ▶
- 16. 572 PART 6 Long-Term Financial Decisions TOTAL LEVERAGE We also can assess the combined effect of operating and financial leverage on the firm’s risk by using a framework similar to that used to develop the individual concepts of leverage. This combined effect, or total leverage, can be defined as the use of fixed costs, both operating and financial, to magnify the effects of changes in sales on the firm’s earnings per share. Total leverage can therefore be viewed as the total impact of the fixed costs in the firm’s operating and financial structure. Cables, Inc., a computer cable manufacturer, expects sales of 20,000 units at $5 per unit in the coming year and must meet the following obligations: variable operating costs of $2 per unit, fixed operating costs of $10,000, interest of $20,000, and pre- ferred stock dividends of $12,000. The firm is in the 40% tax bracket and has 5,000 shares of common stock outstanding. Table 13.7 presents the levels of earnings per share associated with the expected sales of 20,000 units and with sales of 30,000 units. Table 13.7 illustrates that as a result of a 50% increase in sales (from 20,000 to 30,000 units), the firm would experience a 300% increase in earnings per share (from $1.20 to $4.80). Although it is not shown in the table, a 50% decrease in sales would, conversely, result in a 300% decrease in earnings per share. The linear nature of the leverage relationship accounts for the fact that sales changes of equal magnitude in opposite directions result in EPS changes of equal magnitude in the corresponding direction. At this point, it should be clear that whenever a firm has fixed costs—operating or financial—in its structure, total leverage will exist. Example 13.12 ▶ total leverage The use of fixed costs, both operating and financial, to magnify the effects of changes in sales on the firm’s earnings per share. The Total Leverage Effect 150% Sales (in units) 20,000 30,000 Sales revenuea $100,000 $150,000 Less: Variable operating costsb 40,000 60,000 DOL = +60, +50, = 1.2 Less: Fixed operating costs 10,000 10,000 Earnings before interest and taxes (EBIT) $ 50,000 $ 80,000 160% DTL = +300, +50, = 6.0 Less: Interest 20,000 20,000 Net profits before taxes $ 30,000 $ 60,000 Less: Taxes (T 5 0.40) 12,000 24,000 Net profits after taxes $ 18,000 $ 36,000 Less: Preferred stock dividends 12,000 12,000 DFL = +300, +60, = 5.0 Earnings available for common stockholders $ 6,000 $ 24,000 Earnings per share (EPS) $6,000 5,000 = $1.20 $24,000 5,000 = $4.80 1300% a Sales revenue 5 $5/unit 3 sales in units. b Variable operating costs 5 $2/unit 3 sales in units. TABLE 13.7 ¯ ˚ ˘ ˚ ˙ ¯ ˚ ˚ ˚ ˚ ˚ ˚ ˘ ˚ ˚ ˚ ˚ ˚ ˚ ˙ ¯ ˚ ˚ ˚ ˚ ˚ ˚ ˚ ˘ ˚ ˚ ˚ ˚ ˚ ˚ ˚ ˙
- 17. ChAPTER 13 Leverage and Capital Structure 573 Measuring the degree of Total Leverage (dTL) The degree of total leverage (DTL) is a numerical measure of the firm’s total le- verage. It can be computed much like operating and financial leverage are com- puted. One approach for measuring DTL is10 degree of total leverage (DTL) The numerical measure of the firm’s total leverage. 10. This approach is valid only when the same base level of sales is used to calculate and compare these values. In other words, the base level of sales must be held constant if we are to compare the total leverage associated with different levels of fixed costs. 11. By using the formula for DTL in Equation 13.9, it is possible to get a negative value for the DTL if the EPS for the base level of sales is negative. For our purposes, rather than show absolute value signs in the equation, we in- stead assume that the base-level EPS is positive. DTL = Percentage change in EPS Percentage change in sales (13.8) Whenever the percentage change in EPS resulting from a given percentage change in sales is greater than the percentage change in sales, total leverage exists. In other words, as long as the DTL is greater than 1, there is total leverage. Applying Equation 13.8 to the data in Table 13.7 yields DTL = +300, +50, = 6.0 Because this result is greater than 1, total leverage exists. The higher the value is, the greater the degree of total leverage. A more direct formula for calculating the degree of total leverage at a given base level of sales, Q, is given by the following equation,11 which uses the same nota- tion that was presented earlier: Example 13.13 ▶ DTL at base sales level Q = Q * (P - VC) Q * (P - VC) - FC - I - aPD * 1 1 - T b (13.9) Substituting Q 5 20,000, P 5 $5, VC 5 $2, FC 5$10,000, I 5 $20,000, PD 5 $12,000, and the tax rate (T 5 0.40) into Equation 13.9 yields DTL at 20,000 units = 20,000 * ($5 - $2) 20,000 * ($5 - $2) - $10,000 - $20,000 - a$12,000 * 1 1 - 0.40 b = $60,000 $10,000 = 6.0 Clearly, the formula used in Equation 13.9 provides a more direct method for calculating the degree of total leverage than the approach illustrated using Table 13.7 and Equation 13.8. Example 13.14 ▶
- 18. 574 PART 6 Long-Term Financial Decisions Relationship of Operating, Financial, and Total Leverage Total leverage reflects the combined impact of operating and financial leverage on the firm. High operating leverage and high financial leverage will cause total leverage to be high. The opposite will also be true. The relationship between op- erating leverage and financial leverage is multiplicative rather than additive. The relationship between the degree of total leverage (DTL) and the degrees of oper- ating leverage (DOL) and financial leverage (DFL) is given by DTL = DOL * DFL (13.10) Substituting the values calculated for DOL and DFL, shown on the right-hand side of Table 13.7, into Equation 13.10 yields DTL = 1.2 * 5.0 = 6.0 The resulting degree of total leverage is the same value that we calculated directly in the preceding examples. The Focus on Ethics box considers some ethical issues relating to the topic of leverage. Example 13.15 ▶ Lehman Brothers’ fall was perhaps the most stunning development of the financial crisis. Dating back to the mid-1800s, the firm had survived the Great Depres- sion and numerous recessions to be- come a major player on Wall Street and around the world. Lehman’s busi- ness included investment banking, sales, research and trading, investment management, private equity, and pri- vate banking. Lehman was also a major player in the subprime mortgage indus- try, which would ultimately lead to the firm’s undoing. In the years before the subprime mortgage crisis, financial firms bor- rowed heavily, and Lehman was no exception. By early 2008, Lehman had $32 in debt for each $1 in equity. That much leverage implied that a small drop in the value of Lehman’s assets could wipe out the firm. Lehman’s exposure to the sub- prime mortgage industry left it vulnera- ble during the crisis. As its financial health deteriorated, Lehman used off– balance sheet transactions to hide the extent of its indebtednesses. The trans- actions, known within Lehman as Repo 105s, were executed near the end of each quarter, just before Lehman filed its quarterly financial reports. In these repos, Lehman sold some of its assets with an agreement to buy them back (with interest) a few days later. Lehman used the cash from the asset sale to pay down other lia- bilities. The Repo 105 transactions enabled Lehman to reduce both total liabilities and total assets and allowed the firm to report lower leverage ratios. With the start of a new quarter, Lehman would unwind the transactions and restore the liabilities to their bal- ance sheet. The effects of Lehman’s Repo 105 transactions were sizable, allowing the firm to briefly remove as much as $50 billion in debt from its balance sheet. Because Lehman did not detail the Repo 105 transactions in its financial state- ments, outsiders were unaware of the transactions. Within Lehman, concerns were raised over the Repo 105 pro- gram. The firm’s global financial control- ler warned of the reputational risk to Lehman if the public became aware of the firm’s reliance on such transactions. ▶ Assume that Lehman’s Repo 105 transactions fall within the limits al- lowed by generally accepted account- ing principles as Lehman’s manage- ment has argued. What are the ethical implications of undertaking transactions expressly to temporarily hide how much money a firm has borrowed? focus on EThICS Repo 105 in practice
- 19. ChAPTER 13 Leverage and Capital Structure 575 LG 4 LG 3 ➔ REVIEW QuESTIONS 13–1 What is meant by the term leverage? How are operating leverage, finan- cial leverage, and total leverage related to the income statement? 13–2 What is the operating breakeven point? How do changes in fixed oper- ating costs, the sale price per unit, and the variable operating cost per unit affect it? 13–3 What is operating leverage? What causes it? How is the degree of oper- ating leverage (DOL) measured? 13–4 What is financial leverage? What causes it? How is the degree of finan- cial leverage (DFL) measured? 13–5 What is the general relationship among operating leverage, financial le- verage, and the total leverage of the firm? Do these types of leverage complement one another? Why or why not? 13.2 The Firm’s Capital Structure Capital structure is one of the most complex areas of financial decision making because of its interrelationship with other financial decision variables. Poor capi- tal structure decisions can result in a high cost of capital, thereby lowering the NPVs of projects and making more of them unacceptable. Effective capital struc- ture decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects and thereby increasing the value of the firm. TYPES OF CAPITAL All the items on the right-hand side of the firm’s balance sheet, excluding current liabil- ities, are sources of capital. The following simplified balance sheet illustrates the basic breakdown of total capital into its two components, debt capital and equity capital: Balance Sheet Long-term debt Assets Stockholders’ equity Preferred stock Common stock equity Common stock Retained earnings Current liabilities Equity capital Debt capital Total capital The cost of debt is lower than the cost of other forms of financing. Lenders de- mand relatively lower returns because they take the least risk of any contributors of long-term capital. Lenders have a higher priority of claim against any earnings or assets available for payment, and they can exert far greater legal pressure against the company to make payment than can owners of preferred or common stock. The tax deductibility of interest payments also lowers the debt cost to the firm substantially. MyFinancelab Video