Capital Structure

Degree of operating leverage

An index for a *specific level* of sales that measures the effect of change in sales (S) on the firm's operating income (EBIT). Alternatively, it is an indicator of the riskiness (variability) of a firm's EBIT to the use of fixed costs (F) in the firm's cost structure.

degree of financial leverage

An index for a specific range of sales that measures the effect of a change in EBIT on a firm;s earnings per share (ESP). At a constant level of sales, the DFL value will vary with a change in the amount of interest expense (I) incurred. This implies that the DFL is an indicator of a firm's *financial* risk.

Degree of total leverage

An index of the firm;s total risk resulting from its use of operating and financial leverage. Stated differently, it is an indicator of the consequences for the firm's EPS for its use of *fixed* operating and financial costs.

Bankruptcy Costs

As you increase debt(More Risk): 1) Increase costs 2) Increase Interest Rates 3) Increase Tax Rates Increase the probability of being bankrupted

Risk

Business and Financial Risk

The differential tax treatment of interest payments and dividend payments encourages firms to use _______ in their capital structure.

DEBT

Executives of the Donut Shop have determined that the company s DOL is 3X and its DFL is 6X. According to this information, how will Donut Shop's EPS be effected if its amount of EBIT turns out to be 4 percent higher than expected?

DFL=6 DOL=3 Use DFL formula 6= x/4 EPS=24%

Axiom company's DFL is 1.5X. Axiom knows that if sales increase by 10 percent its EPS will increase by 30 percent. What is Axiom's DOL?

DTL= EPS/SALES .3/.1 DTL=3X 3= DOL X 1.5 DOL= 1.5x

EPS and DPS are maxed at

Debt Ratio

Trade Off Theory

Debt and Bankruptcy Costs

Sale of preferred stock

Does not change the Degree of Op Leverage Increase DFL: EBIT/(EBIT-Interest-(PFD Dividends)/(1-tax rate) Increase Degree of Total Leverage

gross profit - op expenses

EBIT (Op profits)

Times-interest-earned (TIE)

EBIT / Interest expense shows how well a firm can cover its interest payments with operating income

DFL value is large

EBIT is more sufficient to cover the firm's fixed capital costs then a small change in the firm's EBIT can be magnified many times in the firm's EPS

The net operating income (EBIT) for Bear Investment Company (BIC) this year is $80,000. During the year, the company paid $20,000 in interest on its debt and $25,000 in dividends to its common stockholders. If BIC's marginal tax rate is 40 percent, way is the company's DFL

EBIT/ EBIT-Interest 80k/80k-20k 80/60 DFL=1.33X

DFL (at EBIT= $X)

EBIT/(EBIT-Interest-Preferred stock/(1-tax rate)

EBIT-Interest

Earnings Before Taxes

the decision to use capital intensive technologies will have no effect on a firm's DOL

False; raises operating costs of a firm as well as the business risk and DOL

U.S. firms have more debt and less equity than Germany or Japan

False; variations

Which firm has more financial risk? Which firm has more business risk? ~Scorecard Corp.~ Total assets: $4,400,000 Total debt : $1,012,000 Expected NOPAT: $1,056,000 Std dev. expected NOPAT: $294,800 ~Mob Coffee Inc.~ Total assets: $4,400,000 Total debt : $1,980,000 Expected NOPAT: $1,056,000 Std dev. expected NOPAT: $189,200

Financial risk = Mob Coffee Inc. (has more total debt) Business risk = Scorecard Corp (has higher std dev. of expected NOPAT)

Financial Risk

Firm's Financial Obligations (Debt, Preferred Stock) Increase in leverage increases the business risk by shareholders Risk that is borne solely by the firm's shareholders and results from a firm's decision to finance its assets using fixed cost sources of capital, including debt and preferred stock

Business Risk

Firm's Operations 1) Sales variability (Volume and price) 2) Input Cost Variability 3) Output pricing power 4) Fixed costs-Price does not change (Op leverage) The level and nature of risk attributable to a firm's activities and operations, and ignoring the risks associated with the firm's capital structure.

HL

High Leverage

Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $20 million in assets, $4 million of EBIT, and is in the 40 percent marginal tax rate. LL has a 30% Debt/Asset ratio and pays only 10 percent interest.

LL EBIT=4,000,000 Interest=600,000 Assets times debt ratio times interest payout 4 M x 30% x 10% Earnings before Taxes= 3,400,000 Taxes= 1,360,000 EBT x Tax Rate 3,400,000 x 40% NI= 2,040,000 Debt is 30% .3(20)=6 M Equity= 14 Million ROE: NI/Total Equity 2040000/14000000= 14.6%

LL

Low leverage

good prospects

Management would use more debt Would want to sell stocks cheaply

optimal

Min WACC(Debt)= decrease in a firm's value Goal-Max Firm Value

Earnings Before Taxes - Taxes

Net income

% change formula

New-Old/Old

target capital structure

Optimal and trade off of risk/return

Levered Beta (B)

Previous Beta x (1+((1-tax rate) x (D/A / E/A)

EBIT=

Sales minus fixed cost minus sales x variable costs ratio

Debt

Tax Shelter Benefits Interest is tax deductible(Subsidize(Cheap) Debt Cheaper source of capital not because of priority Used well will increase the firm's Earnings Per Share

EPS indifference point

The level of sales at which a firm;s earnings per share (EPS) are the same, regardless of which of two alternative capital structures are compared.

Asymmetric Information

The situation in which outsiders, such as external shareholders, credits, suppliers, and customers have less and inferior information about a firm's past, current, and future conditions and prospects, compared to the firm's managers.

Debt to asset ratio

Total Debt/ total assets

Italy and Japan use more debt than USA and Canada

True; different countries

A firm has determined that its DOL is 2.0X and its DFL is 1.5X. As a result, what will be the change in its EPS if sales are 10 percent lower than expected?

Use DTL Formula EPS/SALES 3= X/-10% EPS will be down 30%

operating leverage

a firm's use of relatively high fixed, as opposed to variable, operating costs, such as capital-intensive productive processes instead of labor intensive methods

use of a less than optimal level of debt financing provides the firm

an increased reserve borrowing capacity. Provides a firm and its managers with increased financial flexibility, and advantage in risky times and industries

Firms with lower Bus risk

can handle more financial risk

actual structure

capital structure exhibited by a firm at a specific point in time, whereas the target capital structure is the long run capital structure at which the firm plans to operate ultimately

Cheap financing options

decline in debt yields to future flexibility

Increase in bus risk

decreases debt

finding the cap structure given numerous debt and equity ratios

each ratio added up dividend by the number given

High TIE Ratio

earnings compared to interest are high. Able to pay back its debts

the reason that the firm's preferred dividends are dividend by (1-tax rate) in the second equation is to adjust for the tax-deductibility of dividends. this adjustment converts them from a pretax basis to an after tax basis

false; pfd stock dividends are not tax deductible. Dividing by (1-tax rate) converts them from their after tax basis to their pre-tax basis.

Sales-Cost of Goods Sold

gross profit

high levels of debt cause cost of equity to

increase

TIE ratio less than 1

indicates the firm does not have sufficient earnings to cover its interest payments.

interest is a tax deductible expenses and

is less expensive than equity financing

Debt financing is ________ expensive than common or preferred stock financing.

less

company that would be the most riskiest

look at to see who has the highest degree of total leverage

bad prospects

management will sell stock Debt is limited

if management thinks the firm's stock is undervalued and its prospects are very good while investors are unaware

management will use debt-no ownership

cap structure that max stock price

max shareholder wealth

availability of unusually expense sources of capital

may prompt firms to capitalize on these opportunities and either borrow more or issue new shares of the diff types of stock. Could result in actual cap structure depart from its target cap structure

optimal cap structure is the one that

minimizes the WACC and Max stock price

Trade off of risk/return

more debt Increase in risk decreases the stock price Increase of Earnings Per Shares all being equal increases the stock price

Even if a firm does not declare bankruptcy

most debt contracts stipulate that a firm maintain a certain TIE ratio at some min level in order to borrow additional funds.

even usage of debt and equity

normally is a higher price of stock

DFL value is small

only a small magnification in the firm's EPS will take place when the firm's EBIT changes

Cost of equity

risk free rate of interest + (market risk premium)(levered beta)

reserve borrowing capacity

the ability of a firm to borrow money at a reasonable cost when a good investment opportunities arise because it currently less debt than that suggested of its optimal cap structure

Low TIE Ratio

the number of times a firm can pay interest with earnings are low. Most likely going to take time to pay back its debts

financial leverage

the practice of employing a cap structure that contains a large proportion of fixed cost sources of financing such as debt and preferred stock

if firm is doing bad

they will issue equity to lower the bad fortune around new investors

Equity to Assets ratio

total equity/ total assets

a conservative CEO may be less inclined to finance with debt

true; have highest TIE ratios because they have less debt and thus less interest to cover with earnings

the least leverage industries have the highest TIE Ratios

true; some CEOs are more aggressive than others when using debt, so management attitude infuences the amount of debt that a firm takes on.

capital structure

what mix of debt and equity should we have Combo of debt, PFD and commons stock

Signaling Theory

when management makes a decision-Tell you what to do Decision to issue new common stock vs new debt in repsonse to its evaluation of the firm's future opportunities Good and Bad prospects

Degree of Operating Leverage Formula

% change in EBIT/ % change in Sales Gross Profit/EBIT S-VC/S-VC-FC S=Initial Sales in dollars VC=Total variable costs in dollars F= Fixed op costs

degree of financial leverage formula

% change in EPS/ % Change in EBIT EBIT/EBIT-Interest

Degree of total leverage formula

% change in EPS/ % Change in Sales DOL X DFL

WACC

(D/A)(before-tax COD)(1-tax rate) + (E/A)(COE) COD = cost of debt COE = cost of equity

Debt-to-Equity Ratio

(Debt/Assets)/(Equity/Assets)

Corporations ______ allowed to deduct interest payments as an expense.

ARE

Corporations _______ allowed to deduct payments to stockholders as an expense.

ARE NOT