Chapter 14:

Capital Structure & Leverage

(
)




(Break Even Point BEP)

14-1

ASSET

Liability

Equity

14-2

 ()

z ()

z

z

z
z
()

z
z


(rs) (beta
[] )
z

14-3



z
z

z

z
(Opportunity Cost)
z () - EPS
, ROE
z dilution

14-4



2 :
z
(WACC)
discount rate

z (Financial
Risk)
Beta (CAPM)

14-5

V =

t =1

FCFt
t
(1 + WACC)

WACC = wd (1-T) rd + we rs
V = (value of firm)
FCF = (free cash flow)
WACC =
(weighted average cost of capital)
(cost of stock) (Cost of debt)
re rd

we wd

14-6


Business Risk versus Financial Risk

Business risk:
z.
z

Operation Leverage

Financial risk:
z

z

Financial Risk
14-7

 (business risk)
(pre-tax
operating income (EBIT)).

Probability
Low risk
High risk

E(EBIT)

EBIT

14-8

 Business Risk
Demand (unit sales).
Sales prices.
Input cost variability.

Cost pushing

Ability to develop new product
Forex risk exposure
Fixed cost
14-9

 Operation Leverage

Operating leverage

Operating leverage

Operating
leverage

14-10

operating leverage

Rev.

Rev.
$
TC

} EBIT
TC
F

F
QBE

Sales

QBE

Sales
(More...)
14-11

Probability

Low operating leverage

High operating leverage

EBITL

EBITH

Operation Leverage

14-12

 Financial Risk

Financial risk:
z
z


(Default risk)

14-13

 2

U

L
10,000 12%

5,000

$20,000

(1$)
40%

(1$)
40%

5,000
0
$15,000

5,000
$20,000
5,000
10,000
$5,000

14-14

 Financial Leverage
U
$3,000

$3,000
(40%)
1 ,200

$1,800
ROE

9.0%

L
$3,000
1,200
$1,800
720
$1,080
10.8%

14-15


L
.
z :
U: = $1,800.
L: = $1,080 + $1,200 =
$2,280.
z :
U: $1,200; L: $720.

14-16

 Financial Leverage
U
Bad

Economy
Avg.

Good

Prob.
0.25

5,000
$2,000

$2,000
(40%)
800

0.50
7,000
$3,000
0
$3,000
1,200

0.25
9,000
$4,000
0
$4,000
1,600

$1,800

$2,400

$1,200

14-17

 Financial Leverage
L

Bad

Prob.*
0.25

5,000
$2,000

1,200

$ 800
(40%)
320

$ 480

Economy
Avg.

Good

0.50
7,000
$3,000
1,200
$1,800
720
$1,080

0.25
9,000
$4,000
1,200
$2,800
1,120
$1,680

*Same as for Firm U.

14-18


2
z (Asset Management
Ratio)
z (Profitability)
z (Debt Management
Ratio)

z Basic Earning Power (BEP)
z Return on Equity (ROE)
z Times Interest Earned (TIE)

14-19

Firm U
BEP
ROE
TIE

Bad
10.0%
6.0%
n.a.

Avg.
15.0%
9.0%
n.a.

Good
20.0%
12.0%
n.a.

Firm L
BEP
ROE
TIE

Bad
10.0%
4.8%
1.7x

Avg.
15.0%
10.8%
2.5x

Good
20.0%
16.8%
3.3x

14-20

 L U
Basic earning power (EBIT/TA) ROIC
(NOPAT/Capital = EBIT(1-T)/TA)

Financial levergae
L ROE



L ROE

Financial Leverage
14-21


Optimal Capital Structure:

14-22

(Debt
Ratios)
z

Debt/Equity

Debt/Asset

Interest Coverage (Times Interest Earned: TIE)

EBITDA/Interest

Current Ratio

Etc.

Policy

Rating

(
)

14-23

 (Break Even)
Operating breakeven = QBE
QBE = F / (P V)
Q , F , V ,
TC P .
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 $10) = 40.

14-24

 (Break Even)

z
14-25



120
70,000
55

1. 60, 70, 80, 90
2. 80,000 90,000

14-26