HB 307 1st Edition Lecture 18Capital Structure and Leverage Part 1Financial Management- Involves two decisionso 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 ownersRisky 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 earningshigh 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/profitsLeverage and Risk-Two Kinds of Each - Operating Leverage – Relates to a company’s cost structure o Involves relative use of fixed and variable costso 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 EPSo 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 ROEo ROCE = EBIT (1 – tax rate) / debt + equity o When ROCE exceeds after-cost of debt, more leverage improves ROE and EPSo When ROCE is less than after-cost of debt, more leverage makes ROE and EPS worseFinancial 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 leveragePutting 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’sprice- 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 climateThe 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 priceDegree 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 –