Leverage and
Capital Structure
Lecture Note
Prof. Roy Sembel, PhD
PROF. ROY SEMBEL
EDUCATION
1982-86 IPB, Bogor. FMIPA. Major: Statistics, Minor: Economics; Ir., Best Graduate, Cum Laude
1988-90 Rotterdam School of Management, Erasmus University Rotterdam and The Wharton School,
University of Pennsylvania Philadelphia
MBA, Finance/Banking, Best Graduate, With Honours
1991-96 J.M.Katz Graduate School of Business, University of Pittsburgh; Major: Corporate Finance;
Minor: Econometrics; PhD; Dissertation: “IPO Anomalies, Truncated Excess Supply, and
Heterogeneous Information”
WORK EXPERIENCE
1984-87 Teaching Assistant, FMIPA, IPB.
1990
Internship; ABN Bank, European Treasury Department, Amsterdam.
1990-91 Corporate Banking; ABN AMRO Bank Amsterdam
1994-96 Teaching Assistant, University of Pittsburgh.
1994-2000 Co-founder Indonesian Physics Olympic Team /TOFI Foundation & Indonesian
Computer Olympic Foundation TOKI
1997-98 Economics & Finance Staff, Office of Dr (HC) Radius Prawiro, Jakarta.
2000
ACUCA Lecturer: Japan, South Korea, Taiwan, Hong Kong, The Philippines, Thailand
1987-Now Lecturer, Faculty of Economics, Christian University of Indonesia, Jakarta.
1997-2001 Visiting Lecturer at IPMI, Institut PPM, Magister Management Program University of
Indonesia, University of Sam Ratulangi, Universitas Lampung, Magister Akuntansi & Post Graduate
(S2 & S3) Program Faculty of Economics University of Indonesia, Pelita Harapan University. Subjects:
Investment Analysis and Risk Management, Corporate Finance, International Finance, Derivative
Securities, Managerial Economics, Banks & Capital Markets, eBusiness Management.
1998-2001 McKinsey & Co, Jakarta
2001-2006 Direktur Program Magister Manajemen Keuangan Universitas Bina Nusantara,
Co-founder Indonesia Learning Institute (InLIne), Indonesia School of Life (InSchoOL)
2005-2007 Komisaris Independen & Ketua Komite Pemantau Risiko PT Bank Niaga Tbk
2005- Professor in Financial Economics;
Charter member Lembaga Komisaris dan Direksi Indonesia
2006-2008 Academic Expert Advisor, Universitas Ciputra Surabaya,
2006- Owner/Komisaris (PT. Mobee Indonesia, PT MARS Indonesia)
2007- Supervisory Committee Asian Bond Fund Indonesia (TCW Bahana/BI),
Ketua Komite Sertifikasi FPSB Indonesia
2007-2008 Pejabat Dekan FE Universitas Multimedia Nusantara (UMN)
Ketua Umum Partai Barisan Nasional (BARNAS)
2008
Board of Advisor UMN
2008- Ketua Dewan Pembina Partai Barisan Nasional (BARNAS)
Chief Research Officer CAPITAL PRICE
2009- Dean of Business School and Director of Graduate Program, UPH
MISCELLANEOUS
Speaker in many seminars in Indonesia, USA, and Europe. Writer of more than 1000 articles
in KONTAN, GATRA, Sinar Harapan, SWA, Bisnis Indonesia, KOMPAS, Investor, Investor
Daily, Warta Ekonomi, Manajemen & Usahawan Indonesia, InfoBank, Jurnal Pasar Modal,
Media Akuntansi, DIA, Bahana, Jurnal Ekonomi UKI, JAKI, JBR, Scripta Economica UPH,
Jurnal, Sinergi MMUII, published books, Internet.
Learning Objectives
Break-even level of sales.
Operating and financial leverage
and risk.
Risks and returns of leveraged
buy-outs.
Affect of capital structure on value.
Break-even Analysis
Steps to Solution
Construct a chart to find the sales
break-even point = level of sales
necessary to cover operating (not
financial) costs.
This requires that you calculate EBIT
for different unit sales amounts.
The point at which EBIT = 0 is the
break-even level of sales.
Break-even Analysis
Assumptions
 Fixed costs remain constant as quantity changes.
 Variable costs vary as quantity of output
changes: they are constant per unit of output.
Costs
$
Variable Costs
Fixed Costs
Quantity Sold
Fixed vs. Variable Costs
Fixed costs may include salaries,
depreciation, rent.
Variable costs may include
commissions, materials, labor.
Break-even Analysis
Calculation of Break-even Quantity
EBIT = Sales – Variable Costs - Fixed Costs
Find Quantity which results in EBIT = $0
Break-even Analysis
Calculation of Break-even Quantity
FC
Unit Salesbe =
p – vc
Where:
Unit Salesbe =
FC =
p =
vc =
Break-even quantity
Total fixed costs
Sales price per unit
Variable costs per unit
Break-even Analysis
Calculation of Break-even Quantity
FC
Unit Salesbe =
p – vc
Example:
Fixed Costs
= $1,000,000/year
Price
= $800/unit
Variable Costs = $400/unit
Break-even Analysis
Calculation of Break-even Quantity
FC
Unit Salesbe =
p – vc
Example:
Fixed Costs
= $1,000,000/year
Price
= $800/unit
=
Variable Costs = $400/unit
$1,000,000
$800 – $400
= 2,500 units
Break-even Analysis
Now calculate total revenue.
TR = p x Q
p = Sales price per unit
Q = unit sales
Break-even Analysis
Calculate total revenue for different
levels of sales.
TR = p x Q
Unit sales (Q)
0
500
1,000
2,000
2,500
x
x
x
x
x
x
Price (p)
$800
$800
$800
$800
$800
= Total Revenue (TR)
=
$0
=
$ 400,000
=
$ 800,000
=
$1,600,000
=
$2,000,000
Break-even Analysis-Graph
Sales
&
Graphical
Costs
Point
$
Analysis of Break-even
Variable Costs
Fixed Costs
$1,000,000
Quantity of Units
Break-even Analysis-Graph
Sales
&
Graphical
Costs
Point
$
Analysis of Break-even
Total Costs
Variable Costs
Fixed Costs
$1,000,000
Quantity of Units
Break-even Analysis-Graph
Sales
&
Graphical
Costs
Point
$
Analysis of Break-even
Sales
Total Costs
Variable Costs
Fixed Costs
$1,000,000
Quantity of Units
Break-even Analysis-Graph
Sales
&
Graphical
Costs
Point
$
$2,000,000
Analysis of Break-even
Sales
Total Costs
Variable Costs
Fixed Costs
$1,000,000
Qbe = 2,500 Quantity of Units
The Concept of Leverage
You cannot easily move a large boulder.
The Concept of Leverage
However, with the aid of a lever you can
move an object many times your size.
The Concept of Leverage
The longer the lever, the bigger the
rock you can move.
The Concept of Leverage
In a financial context, the magnifying
power of leverage can be used to help (or
hurt) a firm’s financial performance.
Operating leverage occurs due to fixed
costs in the production process.
With high fixed costs, a small change in
sales may trigger a large change in
operating income (EBIT).
Operating Leverage
Measurement of Operating Leverage
Degree of Operating Leverage (DOL)
DOL =
% Change in EBIT
% Change in Sales
DOL > 1 means the firm has operating
leverage.
Operating Leverage
Example: fixed costs = $1 and no variable costs
EBIT for Sales of $3 = $3 - $1 = $2
EBIT for Sales of $4 = $4 - $1 = $3
DOL =
% Change in EBIT
% Change in Sales
($3 - $2)/$2
DOL =
($4 - $3)/$3
.50
=
= 1.5
.33
Operating Leverage
Measurement of DOL
Calculation using per unit information:
DOL =
Sales - Total VC
Sales-Total VC-FC
Operating Leverage
Measurement of DOL
Calculation using per unit information:
Sales - Total VC
Sales-Total VC-FC
DOL =
Example:
Q
P
VC
FC
=
=
=
=
3,750 units
$800 per unit
$400 per unit
$1,000,000 per year.
Operating Leverage
Measurement of DOL
Calculation using per unit information:
DOL =
DOL3,750 units =
Sales - Total VC
Sales-Total VC-FC
3,750(800) – 3,750(400)
3,750(800) –3,750(400) – 1,000,000
Operating Leverage
Measurement of DOL
Calculation using per unit information:
Sales - Total VC
Sales-Total VC-FC
DOL =
DOL3,750 units =
=
3,750(800) – 3,750(400)
3,750(800) –3,750(400) – 1,000,000
3
Interpretation: If sales change 1%, then
EBIT will change 3% (same direction).
Operating Leverage
Degree of Operating Leverage falls
as sales rise
Quantity
2,500 (Qbe)
3,250
3,750
5,000
DOL
Undefined
4.33
3
2
Operating Leverage
Degree of Operating Leverage falls
as sales rise
Quantity
2,500 (Qbe)
3,250
3,750
5,000
DOL
Undefined
4.33
3
2
The higher the sales level above break-even,
the less EBIT changes as sales change
If FC = $0, DOL = 1
Financial Leverage
Degree of Financial Leverage
Financial Leverage
Degree of Financial Leverage
 Finance a portion of the firm’s assets with
securities that have fixed financial costs
Debt
Preferred Stock
Financial Leverage
Degree of Financial Leverage
 Finance a portion of the firm’s assets with
securities that have fixed financial costs
Debt
Preferred Stock
 Financial Leverage measures changes in
earnings per share as EBIT changes.
Financial Leverage
Degree of Financial Leverage
 Finance a portion of the firm’s assets with
securities that have fixed financial costs
Debt
Preferred Stock
 Financial Leverage measures changes in
earnings per share as EBIT changes.
% Change in NI
DFLEBIT =
% Change in EBIT
Unique Level of EBIT
Financial Leverage
Measurement of DFL
(Alternative formula)
EBIT
DFLEBIT =
EBIT – I
If DFL > 1, the firm has financial
leverage. An increase in EBIT wil
result in a larger increase in NI.
Financial Leverage
Example:
EBIT =
Interest Charges =
$500,000
$200,000
Financial Leverage
Example:
EBIT =
Interest Charges =
$500,000
$200,000
500,000
DFLEBIT=500,000 = 500,000 – 200,000
= 1.67 times
Financial Leverage
Example:
EBIT =
Interest Charges =
$500,000
$200,000
500,000
DFLEBIT=500,000 = 500,000 – 200,000
= 1.67 times
Interpretation: When EBIT changes 1% (from
an existing level of $500,000) Earnings Per
Share will change 1.67%
Combined Leverage
Degree of Combined Leverage
 Measures changes in Net Income given
changes in Sales
Combined Leverage
Degree of Combined Leverage
 Measures changes in Net Income given
changes in Sales
 Combines both Operating and Financial
Leverage
Combined Leverage
Degree of Combined Leverage
 Measures changes in Net Income given
changes in Sales
 Combines both Operating and Financial
Leverage
 Computed for a specific level of sales
Combined Leverage
Degree of Combined Leverage
 Measures changes in Net Income given
changes in Sales
 Combines both Operating and Financial
Leverage
 Computed for a specific level of sales
% Change in EPS
DCLS = % Change in Sales
Unique Level of Sales
Combined Leverage
DCLS = DOLS x DFLEBIT
Example:
DFLEBIT = 1.67
DOLS = 3.0
Combined Leverage
DCLS = DOLS x DFLEBIT
Example:
DFLEBIT = 1.67
DOLS = 3.0
DCL3,750 = 3.0 x 1.67
= 5.0 times
Combined Leverage
DCLS = DOLS x DFLEBIT
Example:
DFLEBIT = 1.67
DOLS = 3.0
DCL3,750 = 3.0 x 1.67
= 5.0 times
Interpretation: When sales change 1%, Net
Income will change 5.0%
Effect of Leverage
Leverage can help the firm or hurt it.
If EBIT increases, leverage will cause
net income to increase even more.
If EBIT decreases, leverage will
cause a larger decline in net income.
Capital Structure Theory
Capital Structure is the mixture of
sources of funds a firm uses.
Debt
Preferred Stock
Common Stock
Capital Structure Theory
A benefit of debt financing is that
interest is tax deductible whereas
payments to equity providers are not.
Firms must trade off this benefit
against the increased financial risk
associated with higher debt levels.
Capital Structure Theory
-Modigliani and Miller (MM)
MM wrote an important paper in 1958 in
which they proved that with tax
deductibility of interest payments, the
optimal capital structure is 100% debt.
Assumptions: No transaction costs, no
taxes, everyone has same information and
borrowing rates, debt is riskless, debt
does not affect operations.
Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering going into
debt. (Maybe some of the original shareholders want to cash
out.)
Current
Assets
$20,000
Debt
$0
Equity
$20,000
Debt/Equity ratio
0.00
Interest rate
n/a
Shares outstanding 400
Share price
$50
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
EPS and ROE Under Current Capital Structure
RecessionExpectedExpansion
EBIT
$1,000 $2,000 $3,000
Interest
0
0
0
Net income $1,000 $2,000 $3,000
EPS
$2.50
$5.00
$7.50
ROA
5%
10%
15%
ROE
5%
10%
15%
Current Shares Outstanding = 400 shares
EPS and ROE Under Proposed Capital Structure
RecessionExpectedExpansion
EBIT
$1,000 $2,000 $3,000
Interest
640
640
640
Net income $360 $1,360 $2,360
EPS
$1.50
$5.67
$9.83
ROA
5%
10%
15%
ROE
3%
11%
20%
Proposed Shares Outstanding = 240
shares
EPS and ROE Under Both Capital
All-Equity
Structures
Recession
Expected
Expansion
EBIT
$1,000
Interest
0
Net income
$1,000
EPS
$2.50
ROA
5%
ROE
5%
Current Shares Outstanding = 400 shares
EBIT
Interest
Net income
EPS
ROA
ROE
Levered
Recession
$1,000
640
$360
$1.50
5%
3%
Proposed Shares Outstanding = 240 shares
$2,000
0
$2,000
$5.00
10%
10%
$3,000
0
$3,000
$7.50
15%
15%
Expected
$2,000
640
$1,360
$5.67
10%
11%
Expansion
$3,000
640
$2,360
$9.83
15%
20%
Financial Leverage and EPS
12.00
Debt
10.00
EPS
8.00
6.00
4.00
No Debt
Advantage
to debt
Break-even
point
2.00
0.00
1,000
(2.00)
Disadvantage
to debt
2,000
3,000
EBIT
EBI in dollars, no taxes
Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-equity firm
S
G
Levered firm
S
G
B
The levered firm pays less in taxes than does the allequity firm.
Thus, the sum of the debt plus the equity of the levered
firm is greater than the equity of the unlevered firm.
Integration of Tax Effects and Financial Distress Costs
 Because costs of financial distress can be reduced but not
eliminated, firms will not finance entirely with debt.
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)
Present value of tax
shield on debt
VL = VU + TCB
Maximum
firm value
Present value of
financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
Debt (B)
0
B*
Optimal amount of debt
Capital Structure in the Real World
Firms attempt to balance the costs and
benefits of debt to reach the optimal mix
that maximizes the value of the firm.
Affect on costs of capital:
Capital Structure in the Real World
Firms attempt to balance the costs and
benefits of debt to reach the optimal mix
that maximizes the value of the firm.
Affect on costs of capital:
Since debt is cheaper than equity, use
of debt will initially lower the WACC.
At high levels of debt, the WACC will
increase as investors perceive the firm
to be riskier.