Determining the Finance Mix
Learning Objectives
1.
Understanding the difference between risk and financial risk.
2.
Use the technique of break-even analysis in a variety of
analytical settings.
3.
Distinguish among the financial concepts of operating
leverage, financial leverage, and combined leverage.
4.
Calculate the firm’s degree of operating leverage, financial
leverage, and combined leverage.
5.
Understand the concept of an optimal capital structure.
Learning Objectives
6.
7.
8.
9.
10.
Explain the main underpinnings of capital structure
theory.
Understand and be able to graph the moderate position
on capital structure importance.
Incorporate the concepts of agency costs and free cash
flow into a discussion on capital structure management.
Use the basic tools of capital structure management.
Understand how business risk and global sales impact
the multinational firm.
Slide Contents
1.
2.
3.
4.
5.
6.
7.
8.
9.
Principles Used in this chapter
Risk
Break-even Analysis
Operating and Financial leverage
Planning the Financing Mix
Capital Structure Theory
Capital Structure Management (Basic Tools)
Capital Structure Management (Survey Results)
Finance and the Multinational Firm
1. Principles Used in this Chapter
Principles Used in this Chapter
• Principle 1:
– The Risk-Return Tradeoff – We Won’t Take on Additional
Risk Unless We Expect to Be Compensated With Additional
Return
• Principle 3:
– Cash-Not Profits-Is King
• Principle 7:
– The Agency Problem – Managers Won’t Work for the
Owners Unless It’s in Their Best Interest
• Principle 8:
– Taxes Bias Business Solutions
2. Risk
Risk
• The variability associated with expected revenue or
income streams. Such variability may arise due to:
– Choice of business line (business risk).
– Choice of an operating cost structure (operating risk).
– Choice of capital structure (financial risk).
Business Risk
•
Business Risk is the variation in the firm’s expected earnings
attributable to the industry in which the firm operates. There
are four determinants of business risk:
1. The stability of the domestic economy
2. The exposure to, and stability of, foreign economies
3. Sensitivity to the business cycle, and
4. Competitive pressures in the firm’s industry.
Operating Risk
• Operating risk is the variation in the firm’s operating
earnings that results from the firm’s cost structure
(mix of fixed and variable operating costs).
• Earnings of firms with higher proportion of fixed
operating costs are more vulnerable to change in
revenues.
Financial Risk
 Financial Risk is the variation in earnings as a
result of a firm’s financing mix or proportion of
financing that requires a fixed return.
3. Break-even Analysis
Break-even Analysis
• Break-even analysis is used to determine the
break-even quantity of a firm’s output by
examining the relationships among the firm’s cost
structure, volume of output, and profit.
• Break-even may be calculated in units or sales
dollars. Break-even point indicates the point of
sales or units at which EBIT is equal to zero.
Break-even Analysis

Use of break-even model enables the
financial officer:
1. To determine the quantity of output that must
be sold to cover all operating costs, as distinct
from financial costs.
2. To calculate the EBIT that will be achieved at
various output levels.
Keown Martin
15 Petty Chapter 12
Elements of Break-even Model
 Break-even analysis requires information on the
following:
1. Fixed Costs
2. Variable Costs
3. Total Revenue
4. Total Volume
 Break-even analysis requires classification of costs
into two categories:
– Fixed costs or indirect costs
– Variable costs or direct costs
• Since all costs are variable in the long-run, breakeven analysis is a short-run concept.
Fixed or Indirect Costs
• These costs do not vary in total amount as sales volume or
the quantity of output changes.
– As production volume increases, fixed costs per unit of
product falls, as fixed costs are spread over a larger and
larger quantity of output (but total remains the same).
– Fixed costs vary per unit but remain fixed in total.
– The total fixed costs are generally fixed for a specific range of
output.
Break-even Point (BEP)
• BEP = Point at which EBIT equals zero
• EBIT = (Sales price per unit) (units sold)
– [(variable cost per unit) (units sold) + (total
fixed cost)]
BEP for Pierce Grain Company
Example
• Selling price = $10 per unit
• Variable cost = $6 per unit
• Fixed cost = $100,000
• BEP (Units) = Total Fixed costs
(Unit sales price – Unit variable cost)
= 100000/4 = 25000 units
4. Operating and Financial Leverage
Operating Leverage
• Operating leverage measures the sensitivity of the
firm’s EBIT to fluctuation in sales, when a firm has
fixed operating costs.
• If the firm has no fixed operating costs, EBIT will
change in proportion to the change in sales.
Operating Leverage
• Operating Leverage (OL) = % change in EBIT
% change in sales
• Thus % change in EBIT
= OL X % change in sales
Where :
% change in EBIT = EBITt1 – EBITt / EBITt
% Change in sales =Salest1 – Salest / Salest
Operating Leverage
 Example: If a company has an operating leverage of 6,
then what is the change in EBIT if sales increase by 5%?
Percentage change in EBIT = Operating leverage X
Percentage change in sales = 5% x 6 = 30%
Thus if the firm increases sales by 5%, EBIT will increase by
30%
Operating Leverage
 Operating leverage is present when:
– Percentage change in EBIT / Percentage change in
sales > 1.00
• The greater the firm’s degree of operating
leverage, the more the profits will vary in
response to change in sales.
Operating Leverage for
Pierce Grain
Operating Leverage for
Pierce Grain
• Due to operating leverage, even though the sales
increase by only 20%, EBIT increases by 120%. (and
vice versa, if sales dropped by 20%, EBIT will fall by
120%; see next slide)
• If Pierce had no operating leverage (i.e. all of its
operating costs were variable), then the increase in
EBIT would have been in proportion to increase in
sales, i.e. 20%.
Financial Leverage
• Financial leverage is financing a portion of the firm’s
assets with securities bearing a fixed rate of return in
hopes of increasing the return to the common
stockholders.
• Thus, the decision to use preferred stock or debt exposes
the common stockholders to financial risk.
• Variability of EBIT is magnified by firm’s use of financial
leverage.
Three financing plans for Pierce
Grain
Three financing plans for Pierce
Grain
• Plan A: 0% debt – no financial risk
• Plan B: 25% debt – moderate financial risk
• Plan C: 40% debt – higher financial risk
• See next slide for impact of financial leverage on
earnings per share (EPS). The use of financial
leverage magnifies the impact of changes in EBIT on
earnings per share.
• A firm is employing financial leverage and
exposing its owners to financial risk when:
– Percentage change in EPS divided by Percentage
change in EBIT is greater than 1.00
Combined Leverage
• Operating leverage causes changes in sales revenues to
cause even greater changes in EBIT; furthermore, changes
in EBIT due to financial leverage create large variations in
both EPS and total earnings available to common
shareholders.
• Not surprisingly, combining operating and financial leverage
causes rather large variations in EPS
Combined Leverage
• Combined Leverage = Percentage change in
EPS/Percentage change in sales
• Or combined leverage = Operating Leverage X
Financial Leverage
• See table 12-6
Combining Operating and
Financial Leverage
5. Planning the Financing Mix
Capital Structure
• Financial Structure
– Mix of all items that appear on the right-hand side of
the company’s balance sheet
• Capital Structure
– Mix of the long-term sources of funds used by the firm
– Financial Structure – Current liabilities = Capital
Structure
Financial Structure
 Designing a prudent financial structure requires
answers to the following:
1. How should a firm best divide its total fund sources
between short- and long-term components?
2. Capital structure management: In what proportions
relative to the total should the various forms of
permanent financing be utilized?
• This chapter focuses on the second question.
Capital Structure Management
• A firm should mix the permanent sources of funds in
a manner that will maximize the company’s stock
price, or minimize the cost of capital.
• A proper mix of funds sources is called the “optimal
capital structure”.
6. Capital Structure Theory
Capital Structure Theory
• Theory focuses on the effect of financial leverage
on the overall cost of capital to the enterprise.
• In other words, Can the firm affect its overall cost
of funds, either favorably or unfavorably, by
varying the mixture of financing used?
• Firms strive to minimize the cost of using financial
capital.
M&M’s Independence Hypothesis
• According to Modigliani & Miller, neither the
total value of the firm nor the cost of capital is
influenced by the firm's capital structure. In
other words, the financing decision is
irrelevant!
• Their conclusions were based on restrictive
assumptions (such as no taxes, perfect or
efficient markets).
M&M’s Independence Hypothesis
• Figure 12-5 that shows that firm’s value
remains the same
, despite the differences in
financing mix.
M&M’s Independence Hypothesis
• Figure 12-6 shows that the firm’s cost of
capital remains constant
, although cost of
equity rises with increased leverage.
Extensions to Independence
Hypothesis
• How is the capital structure decision affected
when we consider:
– Tax benefit on interest expense
– Possibility of financial distress
– Agency cost of debt
Impact of taxes on capital
structure
• Interest expense is tax deductible.
• Because interest is deductible, the use of debt
financing should result in higher total market value
for firms outstanding securities.
• Tax Shield benefit = rd(m)(t)
r = rate, m = principal, t = marginal tax rate
• Interest on debt is tax deductible.
==> higher the interest expense,
the taxes
lower
• Thus, one would suggest that firms should maximize
Debt … indeed, firms should go for 100% debt to
maximize tax shield benefits!!
• But, we generally do not see 100% debt in the real
world. Why not?
• Two possible explanations are:
– Bankruptcy costs
– Agency costs
Impact of Bankruptcy on Capital
structure
• The Probability that a firm will be unable to meet its debt
obligations increases with debt. Thus probability of
bankruptcy (and hence costs) increases with increased
leverage. Threat of financial distress causes the cost of debt to
rise.
• As financial conditions weaken, expected costs of default can
be large enough to outweigh the tax shield benefit of debt
financing.
Impact of Bankruptcy on Capital
structure
• So higher debt does not lead to higher value. After a point
debt reduces the value of the firm to shareholders.
• This explains a tendency to restrain from maximizing the use
of debt.
• Debt capacity indicates the maximum proportion of debt the
firm can include in its capital structure and still maintain its
lowest composite cost of capital (see figure 12-7).
Agency Costs
• To ensure that agent-managers act in shareholders best
interest, firms must:
1. Have proper incentives
2. Monitor decisions
-bonding the managers
-auditing financial statements
-structuring the organization in unique ways that limit useful managerial
decisions
-reviewing the costs and benefits of management perquisites
• The costs of the incentives and monitoring must be borne
by the stockholders.
Impact of Agency Costs on Capital
Structur
• Capital structure management also gives rise to agency costs.
Bondholders are principals as essentially they have given a loan
to the corporation, that is owned by shareholders.
• Agency problems stem from conflicts of interest between
stockholders and bondholders. For example, pursuing risky
projects may benefit stockholders, but may not be appreciated
by bondholders
• Bondholders greatest fear is default by corporation or misuse
of funds leading to financial distress.
Impact of Agency Costs on
Capital Structure
• Agency costs may be minimized by agreeing to include
several protective covenants in the bond contract
• Bond covenants impose costs (such as periodic disclosure)
and impose constraints (on the type of project
management can undertake, Collateral, distribution of
dividends, and limits on further borrowing)
• Thus agency costs of debt reduces the attractiveness of
debt and decreases the value of the firm.
• Figure 12-8 indicates the trade-offs. For example,
increasing the protective covenants will reduce the
interest cost but increase the monitoring cost (which
is eventually borne by the shareholders).
Summary of Capital Structure
Theory
• Market value of levered firm
= Market value of unlevered firm
+ Present value of tax shields
- Present value of Financial distress costs
- Present value of agency costs
7. Capital Structure Management
WACC and Debt Ratios
Weighted Average Cost of Capital and Debt Ratios
11.40%
11.20%
11.00%
10.80%
10.40%
10.20%
10.00%
9.80%
9.60%
Debt Ratio
63
100%
90%
80%
70%
60%
50%
40%
30%
10%
20%
9.40%
0
WACC
10.60%
Current Cost of Capital: Disney
• Equity
– Cost of Equity =
– Market Value of Equity =
– Equity/(Debt+Equity ) =
13.85%
$50.88 Billion
82%
• Debt
– After-tax Cost of debt =
– Market Value of Debt =
– Debt/(Debt +Equity) =
7.50% (1-.36) = 4.80%
$ 11.18 Billion
18%
• Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%
Estimating Cost of Equity
Current Beta = 1.25
Unlevered Beta = 1.09
Market premium = 5.5%
T.Bond Rate = 7.00%
Debt Ratio
0%0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
D/E Ratio
1.09
11%
25%
43%
67%
100%
150%
233%
400%
900%
Beta
13.00%
1.17
1.27
1.39
1.56
1.79
2.14
2.72
3.99
8.21
Cost of Equity
13.43%
13.96%
14.65%
15.56%
16.85%
18.77%
21.97%
28.95%
52.14%
t=36%
Estimating Cost of Debt
D/(D+E)
D/E
$ Debt
0.00%
0.00%
$0
10.00%
11.11%
$6,207
Calculation Details
= [D/(D+E)]/( 1 -[D/(D+E)])
= [D/(D+E)]* Firm Value
Step
EBITDA
Depreciation
EBIT
$5,559
Interest
Taxable Income
Tax
Net Income $3,558
$6,693
$1,134
$5,559
$0
$5,559
$2,001
$3,272
$6,693
$1,134
Kept constant as debt changes.
$447
= Interest Rate * $ Debt
= EBIT - Interest
$5,112
= Tax Rate * Taxable Income
$1,840
= Taxable Income - Tax
2
Pre-tax Int. cov
Likely Rating AAA
Interest Rate
Eff. Tax Rate 36.00%
∞
AAA
7.20%
36.00%
12.44
= EBIT/Int. Exp
Based upon interest coverage
7.20%
Interest rate for given rating
See notes on effective tax rate
3
4
5
After-tax kd 4.61%
4.61%
=Interest Rate * (1 - Tax Rate)
1
Firm Value = 50,888+11,180= $62,068
66
The Ratings Table
If Interest Coverage
Ratio is
Estimated
Bond Rating
Default
spread
> 8.50
6.50 - 8.50
5.50 - 6.50
4.25 - 5.50
3.00 - 4.25
2.50 - 3.00
2.00 - 2.50
1.75 - 2.00
1.50 - 1.75
1.25 - 1.50
0.80 - 1.25
0.65 - 0.80
0.20 - 0.65
< 0.20
AAA
AA
A+
A
A–
BBB
BB
B+
B
B–
CCC
CC
C
D
0.20%
0.50%
0.80%
1.00%
1.25%
1.50%
2.00%
2.50%
3.25%
4.25%
5.00%
6.00%
7.50%
10.00%
A Test: Can you do the 20% level?
D/(D+E)
D/E
$ Debt
0.00%
0.00%
$0
10.00%
11.11%
$6,207
EBITDA
Depreciation
$6,693
$1,134
$6,693
$1,134
EBIT $5,559
$5,559
Interest Expense
Pre-tax Int. cov
$0
∞
$447
12.44
Likely Rating
Interest Rate
Eff. Tax Rate
AAA
7.20%
36.00%
AAA
7.20%
36.00%
Cost of Debt
4.61%
4.61%
20.00%
Second Iteration
Disney’s Cost of Capital Schedule
Debt Ratio
Cost of Equity
AT Cost of Debt
Cost of Capital
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
13.00%
13.43%
13.96%
14.65%
15.56%
16.85%
18.77%
21.97%
28.95%
52.14%
4.61%
4.61%
4.99%
5.28%
5.76%
6.56%
7.68%
7.68%
7.97%
9.42%
13.00%
12.55%
12.17%
11.84%
11.64%
11.70%
12.11%
11.97%
12.17%
13.69%
8. Capital Structure Management
(Survey Results)
The Ten Factors
•
A survey of 392 corporate executives reveals the
following ten factors as important determinants of
capital structure decision:
1.
Financial flexibility
•
2.
:
Firm’s bargaining position is better if it has choices
Credit Rating:
•
Downgrading of credit rating will increase borrowing costs and
thus managers try to avoid anything that will trigger credit
downgrades
The Ten Factors
3.
Insufficient internal funds
•
4.
5.
Firms follow a pecking order for raising funds – internal
funds followed by debt and then equity.
Level of interest rates
•
:
:
Firms tend to borrow when interest rates are low
relative to their expectations
Interest tax savings
The Ten Factors
6.
Transaction costs and fees
•
7.
8.
Cost of issuing equity is relatively higher than debt, making
equity a less attractive source.
Equity valuation
•
:
:
If shares are undervalued, firms will like to issue debt, and vice
versa.
Competitor:
•
Firms from similar businesses tend to have similar capital
structures.
The Ten Factors
9.
Bankruptcy/distress costs
•
10.
:
Higher existing debt will increase the likelihood of financial
distress.
Customer/supplier discomfort
•
:
High levels of debt will increase discomfort among customers
(fearing disruption in supply) and suppliers (fearing disruption in
demand and late/non payment on existing contracts).
9. Finance and the Multinational Firm
Finance and the Multinational Firm:
Business Risk and Global Sales

Business risk is both multidimensional and
international, and is affected by:
1. The sensitivity of the firm’s product demand to
general economic conditions
2. The degree of competition to which the firm is
exposed
3. Product diversification
4. Growth prospects, and
5. Global sales volumes and production output.