FINANCIAL MANAGEMENT PART 13

1. Capital Structure and Leverage Chapter 13

6. Figure 13.1: Business and Financial Risk

9. Table 13.1 As the firm’s debt ratio rises, both EPS and ROE rise dramatically. While EAT falls, the number of shares outstanding falls at a faster rate as debt replaces equity.

11. Table 13.2 ABC is now doing rather poorly—ROE and ROCE are quite low. As the firm adds leverage, EPS and ROE decrease.

12. Financial Leverage—Example Q: Selected financial information for the Albany Corporation follows: Example Stock price = $10 per share ROE = EAT  equity = $13,500  $90,000 = 15% EPS = EAT  number of shares = $13,500  9,000,000 = $1.50 $13,500 EAT 9,000,000 Number of shares= 9,000 Tax (@40%) $100,000 Capital $22,500 EBT 90,000 Equity 1,200 Interest (@12%) $10,000 Debt $23,700 EBIT Albany Corporation at $10M Debt ($000 except for per-share amounts) The treasurer feels debt can be traded for equity without immediately affecting the price of the stock or the rate at which the firm can borrow. Management believes it is in the best interest of the company and its stockholders to move the firm’s EPS from its current level up to $2.00 per share. However, no opportunities are available to increase operating profit (EBIT) above the current level of $23.7 million. Will borrow more money and retiring stock raise Albany’s EPS, and if so what capital structure will achieve an EPS of $2.00?

13. Financial Leverage—Example A: EPS will rise if ROCE exceeds the after-tax cost of debt. ROCE is currently: Example The after-tax cost of debt is 12% x (1 – 0.4), or 7.2%. Since 7.2% < 14.2%, trading equity for debt will increase EPS. Using trial and error, you can determine that $45 million of debt is the approximate amount of debt that makes the firm’s EPS equal $2.00.

19. Figure 13.2: The Effect of Leverage on Stock Price

24. The Degree of Financial Leverage (DFL)—A Measurement—Example Q: Selected income statement and capital information for the Moberly Manufacturing Company follow ($000): Example Currently 700,000 shares of common stock are outstanding. The firm pays 15% interest on its debt and anticipates that it can borrow as much as it reasonably needs at that rate. The income tax rate is 40% Moberly is interested in boosting the price of its stock. To do that management is considering restructuring capital to 50% debt in the hope that the increased EPS will have a positive effect on price. However, the economic outlook is shaky, and the company’s CFO thinks there’s a good chance that a deterioration in business conditions will reduce EBIT next year. At the moment Moberly’s stock sells for its book value of $10 per share. Estimate the effect of the proposed restructuring on EPS. Then use the degree of financial leverage to assess the increase in risk that will come along with it. $8,000 Total $1,380 EBIT 7,000 Equity 4,200 Cost/expense $1,000 Debt $5,580 Revenue Capital

25. The Degree of Financial Leverage (DFL)—A Measurement (Example) A: Since the equity is trading at book value, this is a relatively simple example. Example 400,000 700,000 Shares outstanding Proposed Current $8,000 $8,000 Total 4,000 7,000 Equity $4,000 $1,000 Debt Capital $1.170 $1.054 EPS $468 $738 EAT Proposed Current 312 492 Tax (@40%) $780 $1,230 EBT 600 150 Interest (15% of debt) $1,380 $1,380 EBIT If business conditions remain unchanged, a higher EPS will result with the addition of debt.

26. The Degree of Financial Leverage (DFL)—A Measurement—Example A: Next, calculate DFL: Example EPS will be much more volatile under the proposed plan. EPS will change by a factor of 1.77 vs. 1.12.

28. Figure 13.3: EBIT – EPS Analysis for ABC Corporation (from Table 13.1, Columns 1 and 2) When examining the ABC Corporation you can see that the 50% Debt and No Leverage lines intersect. At the point of intersection ABC is indifferent between the two plans. However, to the left of the intersection the 50% Debt plan is preferable, but to the right of the point the No Leverage plan is preferable. It is important to determine the indifference point, which occurs when the two plans offer the same EBIT.

32. Figure 13.5: The Breakeven Diagram

34. Breakeven Analysis—Example Q: Suppose a company can make a unit of product for $7 in variable labor and materials, and sell it for $10. What are the contribution and contribution margin? A: The contribution per unit is $3, or $10 - $7, while the contribution margin is $3  $10, or 30%. Example

36. Breakeven Analysis—Example Q: What is the breakeven sales level in units and dollars for a company that can make a unit of product for $7 in variable costs and sell it for $10, if the firm has fixed costs of $1,800 per month? A: The breakeven point in units is $1,800  ($10 - $7) = 600 units. The breakeven point in dollars is $10 per unit times 600 units, or $6,000, which could also be calculated as $1,800  0.30. Thus, the firm must sell 600 units per month to cover fixed costs. Example

38. Figure 13.6: Breakeven Diagram at High and Low Operating Leverage

39. The Effect of Operating Leverage—Example Q: Suppose Firm A has fixed costs of $1,000 per period, sells its product for $10, and has variable costs of $8 per unit. Further, suppose Firm B has fixed costs of $1,500 and also sells its product for $10 a unit. Both firms are at the same breakeven point. What variable cost must Firm B have if it is to achieve the same breakeven point as Firm A? State the trade-off at the breakeven point. Which structure is preferred if there’s a choice? A: Both firms have a breakeven point of 500 units (Firm A: $1,000  $2). We need to solve the breakeven formula for Firm B’s variable costs per unit: Q B/E Firm B = F C  (P – V B ) 500 units = $1,500  ($10 – V B ) V B = $7 The preferred structure depends on volatility—if sales are expected to be highly volatile, the lower fixed cost structure might be better in the long run. Example Thus, at breakeven, a $1 differential in contribution makes up for a $500 difference in fixed cost.

41. The Degree of Operating Leverage (DOL)—A Measurement Q: The Albergetti Corp. sells its product at an average price of $10. Variable costs are $7 per unit and fixed costs are $600 per month. Evaluate the degree of operating leverage when sales are 5% and then 50% above the breakeven level. A: First, compute the breakeven volume: $600  ($10 - $7) = 200 units. Breakeven plus 5% is 200 x 1.05 or 210 units, while breakeven plus 50% is 200 x 1.50 or 300 units. DOL at 210 units is: DOL at 300 units is: Example Note that DOL decreases as the output level increases above breakeven.

44. Figure 13.9: The Compounding Effect of Operating Leverage and Financial Leverage

45. The Compounding Effect of Operating and Financial Leverage—Example Q: The Allegheny Company is considering replacing a manual production process with a machine. The money to buy the machine will be borrowed. The replacement of people with a machine will alter the firm’s cost structure in favor of fixed costs, while the loan will move the capital structure in the direction of more debt. The firm’s leverage positions at expected output levels with and without the project are summarized as follows: The economic outlook is uncertain and some managers fear a decline in sales of as much as 10% in the coming year. Evaluate the effect of the proposed project on risk in financial performance. A: The firm’s current DTL is 2 x 1.5, or 3, meaning a 10% decline in sales could result in a 30% decline in EPS. Under the proposal, the DTL will be much higher: 8.75, or 3.5 x 2.5, meaning a 10% drop in sales could lead to a 87.5% drop in EPS. Example 2.5 3.5 Proposed 1.5 2.0 Current DFL DOL

53. Figure 13.11: The Independence Hypothesis

56. Table 13.4 Total payments to investors are higher for the leveraged company. The All Equity firm pays more taxes because it receives no interest expense deduction.

60. Figure 13.12: MM Theory with Taxes In the MM model with taxes value increases steadily as leverage is added. Thus, the firm’s value is maximized with 100% debt. Note that k d remains constant across all levels of debt.

62. Figure 13.13: MM Theory with Taxes and Bankruptcy Costs