Ch. 13: Determining the Financing Mix

1. Debt Common Equity Preferred Ch. 13: Determining the Financing Mix How do we want to finance our firm’s assets?  2000, Prentice Hall, Inc.

2. Determining the Financing Mix • Operating Leverage • Financial Leverage • Capital Structure

3. What is Leverage?

4. What is Leverage?

5. What is Leverage?

6. 2 concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firm’s business risk. 2) Financial Leverage - affects a firm’s financial risk.

7. Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

8. EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

9. FIRM EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

10. FIRM EPS EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

11. Stock- holders FIRM EPS EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

12. Stock- holders FIRM EPS EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

13. Business Risk Affected by: • Sales volume variability • Competition • Cost variability • Product diversification • Product demand • Operating Leverage

14. Operating Leverage • The use of fixed operating costs as opposed to variable operating costs. • A firm with relatively high fixed operating costs will experience more variable operating income if sales change.

16. EBIT Operating Leverage

17. Financial Risk • The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

18. Stock- holders FIRM EPS EBIT Financial Risk • The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

19. Stock- holders FIRM EPS EBIT Financial Risk • The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

20. Financial Leverage • The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

22. EPS Financial Leverage

23. Breakeven Analysis • Illustrates the effects of operating leverage. • Useful for forecasting the profitability of a firm, division or product line. • Useful for analyzing the impact of changes in fixed costs, variable costs, and sales price.

24. Breakeven Analysis $ Quantity

25. Total Revenue $ Quantity

26. Costs • Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions).

27. $ Quantity

28. Total Revenue $ Quantity

29. Total Revenue Total Cost $ { FC Quantity

30. Total Revenue Total Cost $ } EBIT + - { FC Q1 Quantity

31. Total Revenue Total Cost $ } EBIT + - { FC Q1 Quantity Break- even point

32. Operating Leverage • What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?

33. Total Revenue Total Cost $ } EBIT + - { FC Q1 Quantity Break- even point

34. Total Revenue } $ EBIT + { Total Cost = Fixed - FC Q1 Quantity Break- even point

35. With high operating leverage, an increase in sales produces a relatively larger increase in operating income.

36. Total Revenue } $ EBIT + { Total Cost = Fixed - FC Q1 Quantity Break- even point

37. Total Revenue } $ EBIT + { Total Cost = Fixed - FC Q1 Quantity Break- even point Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!

38. Breakeven Calculations

39. F P - V QB = Breakeven Calculations Breakeven point (units of output)

40. F P - V QB = Breakeven Calculations Breakeven point (units of output) • QB = breakeven level of Q. • F = total anticipated fixed costs. • P = sales price per unit. • V = variable cost per unit.

41. F VC S S* = 1 - Breakeven Calculations Breakeven point (sales dollars)

42. F VC S S* = 1 - Breakeven Calculations Breakeven point (sales dollars) • S* = breakeven level of sales. • F = total anticipated fixed costs. • S = total sales. • VC = total variable costs.

43. Analytical Income Statement sales - variable costs - fixed costs operating income - interest EBT - taxes net income

44. Analytical Income Statement } contribution margin sales - variable costs - fixed costs operating income - interest EBT - taxes net income

45. Analytical Income Statement } contribution margin sales - variable costs - fixed costs operating income - interest EBT - taxes net income EBT (1 - t) = Net Income, so, Net Income / (1 - t) = EBT

46. Degree of Operating Leverage (DOL) • Operating leverage: by using fixed operating costs, a small change in sales revenue is magnified into a larger change in operating income. • This “multiplier effect” is called the degree of operating leverage.

47. Degree of Operating Leveragefrom Sales Level (S) % change in EBIT % change in sales DOLs =

48. Degree of Operating Leveragefrom Sales Level (S) % change in EBIT % change in sales DOLs = change in EBIT EBIT change in sales sales =

49. Degree of Operating Leveragefrom Sales Level (S) • If we have the data, we can use this formula:

50. Sales - Variable Costs EBIT DOLs = Degree of Operating Leveragefrom Sales Level (S) • If we have the data, we can use this formula: