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 ObjectivesBusiness Risk and Financial RiskBreak-even analysisOperating leverage, financial leverage, and combined leverageCalculate: operating leverage, financial leverage, and combined leverageOptimal capital structureCapital structure theoryGraph the moderate position on capital structureAgency costs and free cash flowBasic tools of capital structure managementBusiness risk and global salesRiskRiskLikely variability associated with expected revenue or income streamsBusiness Risk Dispersion (variability) in the firm’s expected earnings before interest and taxesFinancial 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 leverageLeverageLeverageFinancial 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 stockholdersOperating leverage Incurrence of fixed operating costs in the firm’s income stream. Combined leverageBreak-even AnalysisBreak-even AnalysisDetermine 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 dollarsShort-run conceptElements of Break-evenElements of Break-evenFixed Costs or Indirect CostsVariable Costs or Direct CostsRevenueVolumeFixed CostsFixed CostsIndirect 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 CostsExamples:–Administrative Salaries–Depreciation–Insurance–Property Taxes–RentVariable CostsVariable CostsDirect CostsFixed per unit of output but vary in total as output changesExamples:–Direct Labor–Direct Materials–Packaging–Sales commissionsRevenue and VolumeRevenue and VolumeTotal Revenue–Total sales dollars –Equal to the selling price per unit multiplied by the quantity soldVolume of output–Firm’s level of operations and may be stated either as a unity quantity or as sales dollarsBreak-even PointBreak-even PointNumber 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 = 0ProblemProblemSelling Price per unit is $10Variable cost per unit is $6Fixed costs are $100,000What is breakeven?Algebraic ApproachAlgebraic ApproachPxQ – [VxQ + F] = 0(PxQ) – (VxQ) – F = 0Q (P-V) = FQb = F/P-VWhere:Q = units sold P = Sales priceQb = break even level of quantityF = Fixed Costs V = Variable Costs$100,000 / 10 – 6 = 25,000Contribution Margin ApproachContribution Margin ApproachSales – variable costs = contribution marginDifference between unit selling price and unit variable costSales 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 DollarsS = Fixed costs / [1 – (Var costs/sales)]100,000/ [1 – (180,000/300,000)]BE in dollars = $250,000BE in units is 25,000 @ $10 = $250,000Operating LeverageOperating LeverageResponsiveness of the firm’s EBIT to fluctuation in SalesHow 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 LeverageExample :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 salesPercentage 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 CalculationDOL = Revenue before fixed costs / EBIT or Sales – Variable costs / (Sales – Variable costs – Fixed costsOperating LeverageOperating LeverageOperating leverage is present when:Percentage change in EBIT / Percentage change in sales > 1.00As the degree of operating leverage increases, the more profits will vary with a percentage change in salesFinancial LeverageFinancial LeverageFinancing a portion of the firm’s assets with securities bearing a fixed rate of returnA firm is employing financial leverage and exposing its owners to financial risk when:Percentage change in EPS / percentage change in EBIT > 1.00Measured by Percentage change in EPS / Percentage change in EBITCombining Operating Combining Operating Leverage and Financial Leverage and Financial LeverageLeverageChanges 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 EPSPercentage change in EPS/Percentage change in salesOperating Leverage X Financial Leverage = Combined LeverageCombined LeverageCombined
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