HB 307 1st Edition Lecture 18 Capital Structure and Leverage Part 1 Financial Management Involves two decisions o Investment What investment will earn highest rate of return What are the risks with this investment What are the alternative uses of funds When should existing assets be replaced o Financing How do I raise capital for a project Should we take the company public What is the optimal mix of debt and equity How much credit should I extend customers Purpose of decisions Increasing wealth of shareholders or owners Risky Nature of Hospitality Industry Financial Leverage and Operating Leverage Financial risk is a result of financial leverage Financial leverage Ratio of fixed capital costs such as debt to equity When industry has high financial leverage Greater opportunity for returns wen earnings high but high chance of insolvency when earnings drop Operating leverage proportion of fixed operating costs in a hotel s cost structure Industry s such as hotel with high operating leverage are very responsive to changes in sales so when sales decrease or increase high impact on earnings profits Leverage and Risk Two Kinds of Each Operating Leverage Relates to a company s cost structure o Involves relative use of fixed and variable costs o Operating leverage has an influence on a firm s business risk Financial Leverage refers to using borrowed money to enhance effectiveness of invested capital Financial leverage of 10 means firm s capital structure contains 10 debt and 90 equity Contributes to financial risk because under certain conditions financial leverage can improve a firm s ROE and EPS o However at other times it may worsen EPS and ROE These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute The Central Issue Can the use of debt increase the value of a firm s equity o Specifically firm s stock price Under certain conditions changing leverage increases stock price The relationship between capital structure and stock price is not precise nor fully understood Financial Leverage Return on capital employed ROCE o Measures profitability of operations before financing charges but after taxes on a basis comparable to ROE o ROCE EBIT 1 tax rate debt equity o When ROCE exceeds after cost of debt more leverage improves ROE and EPS o When ROCE is less than after cost of debt more leverage makes ROE and EPS worse Financial Leverage and Financial Risk Financial leverage is a two edged sword ROE and EPS for leveraged firms experience more variation Financial risk is the increased variability in financial results that comes from additional leverage Putting it Together The effect on Stock price Leverage enhances performance while it adds risk pushing stock prices in opposite directions Enhanced performance makes the expected return on stock higher driving up the stock s price Increased risk driving down the stock s price Real Investor Behavior and the Optimal Capital Structure When leverage is low an increase in debt has a positive effect on investors High debt levels concerns about risk dominate and adding more debt decreases the stock price As leverage increase its effect goes from positive to negative which results in an optimum capital structure Finding Optimum Leverage No way to determine exact amount of leverage for a company at an exact time Levels vary according to nature of business and economic climate The Target Capital Structure Firm s target capital structure is management s estimate of the optimal capital structure Best guess as to the amount of debt that will maximize stock price Degree of Financial Leverage A measurement Financial leverage magnifies changes in EBIT into larger changes in ROE and EPS Degree of financial leverage DFL relates relative changes in EBIT to relative changes in EPS DFL Change in EPS Change in EBIT Or change in EPS DFL x Change in EBIT Easier method of calculating DFL o DFL EBIT EBIT Interest