Determining the Financing Mix
Chapter 12
Foundations of Finance
Keown, Martin, Petty
Target Capital Structure
• Definition
– The target capital structure is defined as the particular
mix of debt, preferred stock and common equity that
will maximize firm’s stock price while also minimizing
the company’s WACC
• Capital structure policy involves a trade-off
between risk and return.
1. Using more debt raises the risk borne by
stockholders.
2. However using more debt generally increases the
expected ROE.
Understanding the Difference between
Business Risk and Financial Risk
Firm’s executives
worried about earnings they report
as low earnings
cause investors to revise their expectations regarding firm’s future prospects
ultimately leading to a decrease in firm’s stock price.
Why Firm’s Income Stream show
variations over different periods
Choice of
Business Line
Choice of an operating
cost structure
Choice of capital
structure
• For example if the business operates in a
highly volatile industry in which revenues
fluctuate with business cycle.
• Greater fixed operating cost increases
variability in operating earnings in response
to changes in revenues. This source of
variation in firm’s earning referred to as
Operating Risk.
• Source of variation in firm’s earnings that
arises from firm’s use of debt known as
Financial Risk.
Business Risk
• Definition
– Risk of firm’s future earnings that is a direct result of the
particular line of business chosen by the firm.
• Four basic determinants of Business Risk.
Operating Leverage
• Definition
– Operating leverage can be defined as the degree
to which a company uses fixed cost in its
operations.
– Higher the fixed cost of a company as a % of total
cost higher the operating leverage.
– For companies with high operating leverage a
small change in company’s revenues (PxQ) will
bring a large change in operating income (EBIT) as
most of the costs are fixed rather than variable.
Operating Leverage
• Example
•
Company A is robotic (high Fixed cost) while Company B is manual (low fixed cost)
Normal economic Conditions. Q=10,000 and P=20/unit
Company A
Robotic
Sales (PxQ)
VC=8/unit
FC = 60,000
Company B
Manual
200,000 Sales (PxQ)
VC=14/unit
FC = 20,000
200,000
Variable cost (VCxQ)
80,000 Variable cost (VCxQ)
140,000
Fixed cost
60,000 Fixed cost
20,000
EBIT
60,000 EBIT
40,000
Operating Leverage
• Example
•
Company A is robotic (high Fixed cost) while Company B is manual (low fixed cost)
Economic conditions suddenly improve, Demand greatly increases for this type
of product. Q=30,000 and P=20/unit
Company A
Robotic
VC=8/unit
FC = 60,000
Company B
Manual
VC=14/unit
FC = 20,000
Sales (PxQ)
600,000 Sales (PxQ)
600,000
Variable cost (VCxQ)
240,000 Variable cost (VCxQ)
420,000
Fixed cost
EBIT
60,000 Fixed cost
300,000 EBIT
20,000
160,000
Operating Leverage
• We can see that whenever Revenues of an organization
increase the impact felt on the EBIT of an organization with
greater fixed cost in its operations will be much greater than
an organization with lower fixed cost built in its operations.
• This is because for Company A, a greater portion of cost is
fixed so as Sales increase no great impact on total operating
cost is produced which leads to a greater EBIT.
• However, for Company B, a greater portion of cost is variable
so as Revenues increase (Q increases), V.C. (increases) and a
greater impact felt on total operating cost leading to a
decreased EBIT.
Operating Leverage
• Example
•
Company A is robotic (high Fixed cost) while Company B is manual (low fixed cost)
Economic conditions take a downhill. Q=1000 and P=20/unit
Company A
Robotic
Sales (PxQ)
Variable cost (VCxQ)
Fixed cost
EBIT
VC=8/unit
FC = 60,000
Company B
Manual
20,000 Sales (PxQ)
8000 Variable cost (VCxQ)
60,000 Fixed cost
(48000) EBIT
VC=14/unit
FC = 20,000
20,000
14000
20,000
(14000)
Operating Leverage
• DOL = Contribution margin/(RBFC)
Net op. income (EBIT)
• Example
Operating Leverage
First Income Statement
Company A
$
%
Company B
$
%
Sales
100,000
100
Sales
100,000
100
Variable cost
-60,000
-60
Variable cost
-30,000
-30
RBFC (CM)
40,000
40
RBFC (CM)
70,000
70
Fixed cost
-30,000
Fixed cost
-60,000
EBIT
10,000
EBIT
10,000
Second Income Statement
Company A
•
$
%
Company B
$
%
Sales
110,000
100
Sales
110,000
100
Variable cost
-66,000
-60
Variable cost
-33,000
-30
RBFC (CM)
44,000
40
RBFC (CM)
77,000
70
Fixed cost
-30,000
Fixed cost
-60,000
EBIT
14,000
EBIT
17,000
This data shows a 10% increase in sales volume leads to a 40% increase in EBIT for
Company A while a 70% increase is seen in Company B as for Company B a greater portion
of cost is fixed.
Operating Leverage
• Example
First Income Statement
Company A
$
%
Company B
$
%
Sales
100,000
100
Sales
100,000
100
Variable cost
-60,000
-60
Variable cost
-30,000
-30
RBFC (CM)
40,000
40
RBFC (CM)
70,000
70
Fixed cost
-30,000
Fixed cost
-60,000
EBIT
10,000
EBIT
10,000
Second Income Statement
Company A
$
%
Company B
$
%
Sales
110,000
100
Sales
110,000
100
Variable cost
-66,000
-60
Variable cost
-33,000
-30
RBFC (CM)
44,000
40
RBFC (CM)
77,000
70
Fixed cost
-30,000
Fixed cost
-60,000
EBIT
14,000
EBIT
17,000
DOL
Co. A
Co. B
CM/EBIT
40,000/10,000 = 4
70,000/10,000 = 7
4x10% = 40%
7x10% = 70%
% increase in sales = 10%
Impact on EBIT
Operating Leverage
• Importance
Financial Leverage
• Definition
– The additional risk stockholders face when the company
decides to use debt as a source of financing.
• Financial leverage can be defined as the extent to which
company uses fixed income securities such as debt.
• With high degree of financial leverage comes high interest
payment. As a result the bottom-line EPS is negatively
impacted by interest payments.
Financial Leverage
Breakeven Point
• Definition
– Breakeven point is the level of sales at which profit is zero. At
Breakeven point sales are equal to fixed cost plus variable cost.
• Number of units at which EBIT = 0