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CSUF FIN 320 - Determining the Financing Mix

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Chapter 12Determining the Financing MixChapter ObjectivesRiskLeverageBreak-even AnalysisElements of Break-evenFixed CostsSlide 9Variable CostsRevenue and VolumeBreak-even PointProblemAlgebraic ApproachContribution Margin ApproachExampleBreak-even in DollarsOperating LeverageOperating LeverageSlide 20Alternative Operating Leverage CalculationSlide 22Financial LeverageCombining Operating Leverage and Financial LeverageCombined LeverageStructureFinancial StructureCapital Structure ManagementCapital Structure TheoryFirm Failure--BankruptcyDebt CapacityAgency CostsCapital Structure Management and Agency CostsCost of Capital-Capital Structure RelationshipChapter 12Chapter 12Determining the Financing MixDetermining the Financing MixChapter ObjectivesChapter ObjectivesBusiness Risk and Financial RiskBreak-even analysisOperating leverage, financial leverage, and combined leverageCalculate: operating leverage, financial leverage, and combined leverageOptimal capital structureCapital structure theoryGraph the moderate position on capital structureAgency costs and free cash flowBasic tools of capital structure managementBusiness risk and global salesRiskRiskLikely variability associated with expected revenue or income streamsBusiness Risk Dispersion (variability) in the firm’s expected earnings before interest and taxesFinancial Risk Additional variability in earnings available to the firm’s common shareholders and the additional chance of insolvency borne by the common shareholder caused by the use of financial leverageLeverageLeverageFinancial Leverage Financing a portion of the firm’s assets with securities bearing a fixed (limited) rate of return in hopes of increasing the ultimate return to the common stockholdersOperating leverage Incurrence of fixed operating costs in the firm’s income stream. Combined leverageBreak-even AnalysisBreak-even AnalysisDetermine the break-even quantity of output by examining the relationships among the firm’s cost structure, volume of output, and profit.Break-even may be calculated in units or sales dollarsShort-run conceptElements of Break-evenElements of Break-evenFixed Costs or Indirect CostsVariable Costs or Direct CostsRevenueVolumeFixed CostsFixed CostsIndirect Costs–Fixed in total amount over some relevant range of output. –As production volume changes, fixed costs per unit of product changes as fixed costs are spread over a changed quantity of output (but total remains the same.)–Vary per unit but remain fixed in totalFixed CostsFixed CostsExamples:–Administrative Salaries–Depreciation–Insurance–Property Taxes–RentVariable CostsVariable CostsDirect CostsFixed per unit of output but vary in total as output changesExamples:–Direct Labor–Direct Materials–Packaging–Sales commissionsRevenue and VolumeRevenue and VolumeTotal Revenue–Total sales dollars –Equal to the selling price per unit multiplied by the quantity soldVolume of output–Firm’s level of operations and may be stated either as a unity quantity or as sales dollarsBreak-even PointBreak-even PointNumber of units or sales dollars that must be produced and sold to arrive at EBIT = $0.[Sales price per unit X Units sold] – [(Variable cost per unit X Units sold) +(Total fixed costs)] =EBIT = 0ProblemProblemSelling Price per unit is $10Variable cost per unit is $6Fixed costs are $100,000What is breakeven?Algebraic ApproachAlgebraic ApproachPxQ – [VxQ + F] = 0(PxQ) – (VxQ) – F = 0Q (P-V) = FQb = F/P-VWhere:Q = units sold P = Sales priceQb = break even level of quantityF = Fixed Costs V = Variable Costs$100,000 / 10 – 6 = 25,000Contribution Margin ApproachContribution Margin ApproachSales – variable costs = contribution marginDifference between unit selling price and unit variable costSales price – variable costs = contribution margin (CM)Fixed costs / CM = Break-even$100,000/ $4 = 25,000ExampleExampleSales $ 300,000Var costs 180,000Revenue 120,000Fixed Costs 100,000EBIT $ 20,000Per unit sales price is $10Per unit variable cost is $6Break-even in DollarsBreak-even in DollarsS = Fixed costs / [1 – (Var costs/sales)]100,000/ [1 – (180,000/300,000)]BE in dollars = $250,000BE in units is 25,000 @ $10 = $250,000Operating LeverageOperating LeverageResponsiveness of the firm’s EBIT to fluctuation in SalesHow will a company respond to a percentage change in sales?Percentage change in EBIT / Percentage change in salesOperating Leverage Operating Leverage Percentage change in EBIT / Percentage change in salesPercentage change in EBIT =EBITt1 – EBITt / EBITtPercentage Change in sales =Salest1 – Salest / SalestOperating LeverageOperating LeverageExample :If a company has an operating leverage of 6, then what is the change in EBIT if sales increase by 5%? Percentage change in EBIT = Operating leverage X Percentage change in salesPercentage change in EBIT = 5% x 6 or 30%If the firm increases sales by 5%, EBIT will increase by 30%Alternative Operating Alternative Operating Leverage CalculationLeverage CalculationDOL = Revenue before fixed costs / EBIT or Sales – Variable costs / (Sales – Variable costs – Fixed costsOperating LeverageOperating LeverageOperating leverage is present when:Percentage change in EBIT / Percentage change in sales > 1.00As the degree of operating leverage increases, the more profits will vary with a percentage change in salesFinancial LeverageFinancial LeverageFinancing a portion of the firm’s assets with securities bearing a fixed rate of returnA firm is employing financial leverage and exposing its owners to financial risk when:Percentage change in EPS / percentage change in EBIT > 1.00Measured by Percentage change in EPS / Percentage change in EBITCombining Operating Combining Operating Leverage and Financial Leverage and Financial LeverageLeverageChanges in sales revenues cause greater changes in EBIT; changes in EBIT create larger variations in both EPS and total earnings available to common shareholders, if the firm chooses to use financial leverage.Combining operating and financial leverage causes rather large variations in EPSPercentage change in EPS/Percentage change in salesOperating Leverage X Financial Leverage = Combined LeverageCombined LeverageCombined


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