Chapter 13 Capital Structure Basics Break even level of sales cover operating costs changes Construct a chart to find the sales break even point level of sales necessary to Assume Fixed costs remain constant and variable costs vary as quantity Fixed salaries depreciation rent etc high fixed cost sell more Variable commissions materials labor etc in long run all costs high variable means sell less Requires calculating EBIT for different unit sales amount EBIT Sales Variable Costs Fixed Costs Break even level of sales is the point where EBIT 0 Break even quantity unit sales Fixed costs Price Variable Costs Total Revenue Sales price per unit X Unit Sales Operating and financial leverage and risk ex Moving a large boulder leverage is the lever used to move rock Amount of debt that a firm uses to finance its assets Magnifying power of leverage can be used to help or hurt a firm s financial performance Operating leverage Business Risk due to fixed costs with high fixed operating costs small change in sales triggers large change in EBIT operating income DOL s Change EBIT Change Sales Change end beginning DOL 1 means firm has operating leverage DOL 1 means fixed costs 0 no fixed costs no leverage Alternate DOL Sales Total VC Sales Total VC FC DOL falls as sales rise volatility of sales causes rise in DOL Higher sales level above break even less change EBIT for change sales Financial leverage Financial Risk Finance a portion of firm s assets with securities that have fixed financial costs debt and preferred stock interest rates do not change measures changes in earnings per share as EBIT changes if no pref stock change in EPS change in net income DFL ebit Change Net Income Change EBIT DFL 1 means firm has financial leverage A given change in EBIT results in a larger change in NI Alternate DFL ebit EBIT EBIT 1 Increased volatility of net income and financial risk caused by fixed financial expenses Combined Leverage measures changes in Net Income given changes in sales combines operating and financial leverage computed for a specific base level of sales DCL s Change Net Income Change Sales Alternate DCL DOL x DFL EBIT Alternate DCL Sales VC Sales VC FC I If fixed operating costs and fixed interest costs 0 no leverage Effect of Leverage can help or hurt magnifies if EBIT increases financial leverage will magnify the increase in net if EBIT decreases financial leverage will magnify the decrease in net income income Volatile sales do not want leverage Banks use lots of leverage Risks and returns of leveraged buy outs LBOs Leveraged buyout Publicly owned corporation that has been bought out by a small group of investors including top management of the firm using a large amount of borrowed money financial leverage Returns debt is tax deductible lower costs Risks financial risk increases risk of bankruptcy suppliers may refuse to extend trade credit Effect of capital structure on value Capital Structure common stock mixture of sources of funds a firm uses debt preferred stock Benefit of debt financing is that interest is tax deductible to the paying firm whereas payments to equity providers dividends are not Firms must trade off this benefit against the increased financial risk associated with higher debt levels balance costs and benefits of debt to reach optimal mix that maximizes the value of the firm Capital structure choices that affect the cost of capital debt is cheaper than equity use of debt lowers WACC high levels of debt causes increase in WACC and rate of return as investors perceive the risk of the firm to be increasing increase cost of capital Chapter 17 Working Capital Policy debt risk Understand the importance of working capital Working capital marketable securities inventory and prepaid expenses cash w in 1 yr amount of firm s current assets cash accounts receivable Managing the level and financing of working capital is necessary keeps costs under control eg storage of inventory when business fluctuates ex seasonal keeps risk levels at an appropriate level eg liquidity Net Working Capital Current Assets Current Liabilities determine correct level balance risk and return benefits of working capital higher liquidity lowers risk costs of working capital To increase firm s working capital current assets sell stock proceeds in bank to reduce illiquidity risk Temporary current assets inventory cash accounts that fluctuate Permanent current assets base level of inventory cash accounts receivable Fixed assets land buildings equipment The liquidity profitability trade off liquidity is a cushion extra cash temporary do not earn firm high return noncurrent earn substantial return long term investments produce most returns safer but as a price high liquidity cash needed soon diminished profitability unproductive unused fixed assets profitability long term produce higher returns benefits measured by net working capital protection from short term better in ST flexibility Determining the optimal level of current assets enough for day to day business and investing extra in short term level that reduces lost sales due to lack of inventory but holding down enhance sales but hold down bad debt and collection Inventory Cash marketable securities inventory costs Accounts receivable expenses through sound credit policies Long Term riskiest Short Term conservative The risk and return implications of alternative approaches to working capital financing policy Conservative Approach finance all fixed assets permanent current assets and some temporary with LT debt or equity ST used for remaining temp current assets lowers risk lowers return more expensive Moderate Maturity Matching Approach finance fixed assets and permanent current assets with LT funds temporary current assets with ST funds moderate risk moderate return Aggressive Approach finance all temporary current assets permanent current assets and some fixed assets with ST debt LT financing used for the remaining fixed assets higher risk higher return lower interest rates Chapter 20 Short Term Financing The need for short term financing profits may not be sufficient to keep up with growth related financing funds firms may prefer to borrow now for their needs rather than wait growth and choice The advantages and disadvantages of short term financing Advantages easier availability lower cost Disadvantages higher risk interest rates are NOT locked in Three types of short term financing Short term loans year or less borrowing from banks and other