Chapter

13

Leverage and Capital Structure

Discuss leverage, capital structure, breakeven analysis, the

operating breakeven point, and the effect of changing costs
on the breakeven point.

Understand operating, financial, and total leverage and the

relationships among them.

Describe the types of capital, external assessment of

capital structure, and capital structure theory.

Explain the optimal capital structure

Review the return and risk of alternative capital structures, their
linkage to market value, and other important capital structure
considerations related to capital structure.
2

Leverage results from the use of fixed-cost assets or

funds to magnify returns to the firms owners.

Generally, increases in leverage result in increases in

risk and return, whereas decreases in leverage result
in decreases in risk and return.

The amount of leverage in the firms capital

structurethe mix of debt and equitycan
significantly affect its value by affecting risk and
return.
3

 The

variability or uncertainty of a
firms operating income (EBIT).

EBIT

FIRM

EPS

Stockholders

 Sales

volume variability
Competition
Product diversification
Operating leverage
Growth prospects
Size

The use of fixed operating costs as opposed to

variable operating costs.

Fixed costs are costs that do not rise and fall with
changes in a firms sales. Firms have to pay these
fixed costs whether business conditions are good
or bad.

A firm with relatively high fixed operating costs

will experience more variable operating income if
sales change.

 The

variability or uncertainty of a firms

earnings per share (EPS) and the
increased probability of insolvency that
arises when a firm uses financial
leverage.

EBIT

FIRM

EPS

Stockholders
7

 The

use of fixed-cost sources of

financing (interest on debt, preferred
stock dividends) rather than variablecost sources (common stock
dividends).

Operating leverage is concerned with the relationship

between the firms sales revenue and its earnings
before interest and taxes (EBIT) or operating profits.
Financial leverage is concerned with the relationship
between the firms EBIT and its common stock
earnings per share (EPS)
Total leverage is the combined effect of operating and
financial leverage. It is concerned with the relationship
between the firms sales revenue and EPS.

10

Breakeven analysis is used to indicate the level of operations

necessary to cover all costs and to evaluate the profitability
associated with various levels of sales; also called costvolume-profit analysis.
1) OPERATING BREAKEVEN POINT
2) FINANCIAL BREAKEVEN POINT

11

The operating breakeven point is the level of sales necessary

to cover all operating costs; the point at which EBIT = $0.
All operating expenses are to be divided into fixed and variable operating
costs.
Fixed costs are costs that the firm must pay in a given period regardless
of the sales volume achieved during that period.
Variable costs vary directly with sales volume.

The financial breakeven point is the level of EBIT necessary

to cover all financing costs.
the financing costs include interest expense and preferred stock dividends
Since level of EBIT and interest expense are before-tax expenses,
preferred dividend must also be adjusted on before-tax.

12

13

EBIT = (P Q) FC (VC Q)
Simplifying yields:
EBIT = Q (P VC) FC
Setting EBIT equal to $0 and solving for Q (the firms
breakeven point) yields:

14

Assume that Cheryls Posters, a small poster retailer,

has fixed operating costs of $2,500. Its sale price is $10
per poster, and its variable operating cost is $5 per
poster. What is the firms breakeven point?

15

16

17

Assume that Cheryls Posters wishes to evaluate the impact of

several options:
increasing fixed operating costs to $3,000,
Operating breakeven point = $3,000/($10 $5) = 600 units

increasing the sale price per unit to $12.50,

Operating breakeven point = $2,500/($12.50 $5) = 333.33 units

increasing the variable operating cost per unit to $7.50,

Operating breakeven point = $2,500/($10 $7.50) = 1,000 units

simultaneously implementing all three of these changes.

Operating breakeven point = $3,000/($12.50 $7.50) = 600 units

18

Operating Breakeven point (units of output)

Q=

F
P-V

Q = breakeven level of Q.
F = total anticipated fixed costs.
P = sales price per unit.
V = variable cost per unit.

19

Operating Breakeven point (sales

dollars)

S* =

F
VC
1S

S* = breakeven level of sales.

F = total anticipated fixed costs.
S = total sales.
VC = total variable costs
20

Operating leverage is the use of fixed operating costs

to magnify the effects of changes in sales on the firms
earnings before interest and taxes.
The figure on the following slide uses the data for
Cheryls Posters (sale price, P = $10 per unit; variable
operating cost, VC = $5 per unit; fixed operating cost,
FC = $2,500)

21

22

23

The degree of operating leverage (DOL) is the

numerical measure of the firms operating leverage.

As long as DOL is greater than 1, there is operating

leverage.

24

Applying the degree of operating leverage equation to

cases 1 and 2 in Table 13.4 yields the following results:

25

% change in EBIT
% change in sales

DOL =

change in EBIT
EBIT
change in sales
sales
26

If we have the data, we can use this formula:

DOL =

Sales - Variable Costs

EBIT
Q(P - V)
Q(P - V) - F

27

The degree of operating leverage at a base sales level,

Q, is the following:

Substituting Q = 1,000, P = $10, VC = $5, and FC =

$2,500 into the above equation yields the following
result:

28

 If

DOL = 2, then a 1% increase in sales

will result in a 2% increase in operating
income (EBIT).

Sales

EBIT

EPS

Stockholders
29

Assume that Cheryls Posters exchanges a portion of its

variable operating costs for fixed operating costs by
eliminating sales commissions and increasing sales
salaries. This exchange results in a reduction in the
variable operating cost per unit from $5 to $4.50 and an
increase in the fixed operating costs from $2,500 to
$3,000.

30

31

Financial leverage is the use of fixed financial costs to

magnify the effects of changes in earnings before
interest and taxes on the firms earnings per share.
The two most common fixed financial costs are
(1) interest on debt and (2) preferred stock dividends.

32

Chen Foods, a small Asian food company, expects EBIT

of $10,000 in the current year. It has a $20,000 bond
with a 10% (annual) coupon rate of interest and an issue
of 600 shares of $4 (annual dividend per share)
preferred stock outstanding. It also has 1,000 shares of
common stock outstanding. The annual interest on the
bond issue is $2,000 (0.10 $20,000). The annual
dividends on the preferred stock are $2,400 ($4.00/share
600 shares). Tax rate is 40%.

33

(EBIT Int) (1 T) Preferred Div = EAT

Setting EAT equal to $0 and solving for EBIT (the

firms financial breakeven point) yields:
EBIT Int = Preferred Div/(1-T)
EBIT = Int + Preferred Div/(1-T)

34

Level of EBIT that will cover all financing costs

EBIT = INT +

PREF. DIV
(1 T)

35

For Chen Foods, the financial breakeven

point is

EBIT = $2,000 + $2,400/(1-0.4)

= $6,000

At EBIT of $6,000, Chen Foods can cover

all its fixed financing cost.

36

37

The degree of financial leverage (DFL) is the

numerical measure of the firms financial leverage.

Whenever DFL is greater than 1, there is financial

leverage.

38

Applying the degree of financial leverage equation to

cases 1 and 2 in Table 13.6 yields the following results:

39

DFL

% change in EPS
% change in EBIT

change in EPS
EPS
change in EBIT
EBIT
40

A more direct formula for calculating the degree of

financial leverage at a base level of EBIT is the
following:

Note that in the denominator, the term 1/(1 T)

converts the after-tax preferred stock dividend to a
before-tax amount for consistency with the other terms
in the equation.
41

Substituting EBIT = $10,000, I = $2,000, PD = $2,400,

and the tax rate (T = 0.40) into the previous equation
yields:

42

If we have the data, we can use this formula:

EBIT
DFL =
EBIT I PD/(1-T)
=

Q(P - V) FC
Q(P - V) FC I PD/(1-T)

43

 If

DFL = 2.5, then a 1% increase in

operating income will result in a 2.5%
increase in earnings per share.

Sales

EBIT

EPS

Stockholders
44

Total leverage is the use of fixed costs, both operating

and financial, to magnify the effects of changes in sales
on the firms earnings per share.
Total Leverage
= Operating Leverage + Financial Leverage

45

Cables Inc., a computer cable manufacturer, expects

sales of 20,000 units at $5 per unit in the coming year
and must meet the following obligations: variable
operating costs of $2 per unit, fixed operating costs of
$10,000, interest of $20,000, and preferred stock
dividends of $12,000. The firm is in the 40% tax
bracket and has 5,000 shares of common stock
outstanding.

46

47

The degree of total leverage (DTL) is the numerical

measure of the firms total leverage.

As long as the DTL is greater than 1, there is total

leverage.

48

Applying the degree of total leverage equation to the data

in Table 13.7 yields the following:

49

A more direct formula for calculating the degree of total

leverage at a given base level of sales, Q, is given by the
following equation:

50

Substituting Q = 20,000, P = $5, VC = $2, FC =

$10,000,
I = $20,000, PD = $12,000, and the tax rate (T = 0.40)
into the previous equation yields:

51

DTL = DOL x DFL

% change in EPS
=
% change in Sales

change in EPS
EPS
change in Sales
Sales
52

If we have the data, we can use this

formula:

DTL =

Sales - Variable Costs

EBIT I PD/(1-T)
Q(P - V)
Q(P - V) - FC I PD/(1-T)
53

 If

DTL = 6, then a 1% increase in sales

will result in a 6% increase in earnings
per share.

Sales

EBIT

EPS

Stockholders
54

55

All of the items on the right-hand side of the firms balance sheet,
excluding current liabilities, are sources of capital. The following
simplified balance sheet illustrates the basic breakdown of total
capital into its two components, debt capital and equity capital.

56

The cost of debt is lower than the cost of other forms of

financing.
Lenders demand relatively lower returns because they take the
least risk of any contributors of long-term capital.
Lenders have a higher priority of claim against any earnings
or assets available for payment, and they can exert far greater
legal pressure against the company to make payment than can
owners of preferred or common stock.
The tax deductibility of interest payments also lowers the debt
cost to the firm substantially.

57

Unlike debt capital, which the firm must eventually repay,

equity capital remains invested in the firm indefinitelyit has
no maturity date.
The two basic sources of equity capital are (1) preferred stock
and (2) common stock equity, which includes common stock
and retained earnings.
Common stock is typically the most expensive form of equity,
followed by retained earnings and then preferred stock.
Whether the firm borrows very little or a great deal, it is
always true that the claims of common stockholders are riskier
than those of lenders, so the cost of equity always exceeds the
cost of debt.

58

A direct measure of the degree of indebtedness is the debt

ratio (total liabilities total assets).
The higher this ratio is, the greater the relative amount of debt (or
financial leverage) in the firms capital structure.

Measures of the firms ability to meet contractual payments

associated with debt include the times interest earned ratio
(EBIT interest) and the fixed-payment coverage ratio.
The level of debt (financial leverage) that is acceptable for one
industry or line of business can be highly risky in another,
because different industries and lines of business have
different operating characteristics.

59

Capital structure is one of the most complex areas of

financial decision making due to its interrelationship
with other financial decision variables.

Poor capital structure decisions can result in a high cost

of capital, thereby lowering project NPVs and making
them more unacceptable.

Effective decisions can lower the cost of capital,

resulting in higher NPVs and more acceptable projects,
thereby increasing the value of the firm.

60

The EPS-EBIT approach to capital structure involves

selecting the capital structure that maximizes EPS over
the expected range of EBIT.

Using this approach, the emphasis is on maximizing the

owners returns (EPS).

A major shortcoming of this approach is the fact that

earnings are only one of the determinants of shareholder
wealth maximization.

This method does not explicitly consider the impact of

risk.

61

EBIT-EPS Analysis - Used to help determine whether it

would be better to finance a project with debt or equity.

EPS =

(EBIT - I)(1 - T) - PD
S

I = interest expense,
P = preferred dividends,
S = number of shares of common stock outstanding.

62

We can plot coordinates on the EBITEPS graph by

assuming specific EBIT values and calculating the EPS
associated with them. Such calculations for three capital
structuresdebt ratios of 0%, 30%, and 60%for
Cooke Company were presented in Table 13.12. For
EBIT values of $100,000 and $200,000, the associated
EPS values calculated there are summarized in the table
below the graph in Figure 13.6.

63

64

When interpreting EBITEPS analysis, it is important to

consider the risk of each capital structure alternative.

Graphically, the risk of each capital structure can be viewed in

light of two measures:
1.
2.

the financial breakeven point (EBIT-axis intercept)

the degree of financial leverage reflected in the slope of the capital
structure line: The higher the financial breakeven point and the
steeper the slope of the capital structure line, the greater the
financial risk.

65

The most important point to recognize when using EBITEPS

analysis is that this technique tends to concentrate on
maximizing earnings rather than maximizing owner wealth as
reflected in the firms stock price.
The use of an EPS-maximizing approach generally ignores
risk.
Because risk premiums increase with increases in financial
leverage, the maximization of EPS does not ensure owner
wealth maximization.

66

A firm currently has 800,000 shares of common

stock outstanding, no debt, and a marginal tax rate
of 40%. We need RM6,000,000 to finance a
proposed project. We are considering two options:

Sell 200,000 shares of common stock at RM30 per

share,

Borrow RM6,000,000 by issuing 10% bonds.

67

Stock Financing

EBIT
- interest
EBT
- taxes (40%)
EAT
# shares outstanding.

EPS

2,000,000
0
2,000,000
(800,000)
1,200,000
1,000,000
RM1.20

Debt Financing

2,000,000
(600,000)
1,400,000
(560,000)
840,000
800,000
RM1.05
68

Stock financing

EBIT
- interest
EBT
- taxes (40%)
EAT
# shares outstanding.

EPS

4,000,000
0
4,000,000
(1,600,000)
2,400,000
1,000,000
RM2.40

Debt financing

4,000,000
(600,000)
3,400,000
(1,360,000)
2,040,000
800,000
RM2.55
69

 If

EBIT is RM2,000,000, common stock

financing is best.

If

EBIT is RM4,000,000, debt financing is

best.

So,

now we need to find a breakeven EBIT

@ EBIT-EPS indifference point where
neither is better than the other.

70

EBIT level where EPS is the same under both the

current and proposed capital structures

If we expect EBIT to be greater than the break-even

point, then leverage is beneficial to our stockholders

If we expect EBIT to be less than the break-even point,

then leverage is detrimental to our stockholders

71

bond
financing

EPS
3

stock
financing

2
1
0

EBIT
$1m

2m

3m

4m
72

Stock Financing
Debt Financing
(EBIT-I)(1-t) - P =
(EBIT-I)(1-t) - P
S
S
(EBIT-0) (1-.40) = (EBIT-600,000)(1-.40)
800,000+200,000
800,000
0.6 EBIT
1
0.48 EBIT
0.12 EBIT
EBIT

=
=
=
=

0.6 EBIT - 360,000

.8
0.6 EBIT - 360,000
360,000
RM3,000,000
73

EPS
3

bond
financing
For EBIT up to RM3 million,
stock financing is best.

stock
financing
For EBIT greater
than RM3 million,
debt financing
is best.

1
0

EBIT
$1m

2m

3m

4m
74

According to finance theory, firms possess a target

capital structure that will minimize its cost of
capital.

Unfortunately, theory can not yet provide financial

mangers with a specific methodology to help them
determine what their firms optimal capital structure
might be.

Theoretically, however, a firms optimal capital

structure will just balance the benefits of debt
financing against its costs.
75

Modigliani and Miller Theory of Capital Structure

Proposition I firm value
Proposition II WACC

The value of the firm is determined by the cash flows

to the firm and the risk of the assets

Changing firm value

Change the risk of the cash flows
Change the cash flows

76

Case I Assumptions
No corporate or personal taxes
No bankruptcy costs

Case 2 Assumptions
Corporate taxes
No bankruptcy costs

Case 3 Assumptions
Corporate taxes
Bankruptcy costs

77

Proposition I
The value of the firm is NOT affected by changes in
the capital structure
The cash flows of the firm do not change; therefore,
value doesnt change

Proposition II
The WACC of the firm is NOT affected by capital
structure

78

Case 1 Proposition II

79

The value of the firm increases by the present value of

the annual interest tax shield
Value of a levered firm = value of an unlevered firm + PV of
interest tax shield
Value of equity = Value of the firm Value of debt

Assuming perpetual cash flows

VU = EBIT(1-T) / RU
VL = VU + DTC

80

Case 2 Proposition I

81

The WACC decreases as D/E increases because of the

government subsidy on interest payments
RA = (E/V)RE + (D/V)(RD)(1-TC)
RE = RU + (RU RD)(D/E)(1-TC)

82

Case II Proposition II

83

Now we add bankruptcy costs

As the D/E ratio increases, the probability of bankruptcy increases

This increased probability will increase the expected bankruptcy

costs

At some point, the additional value of the interest tax shield will
be offset by the increase in expected bankruptcy cost

At this point, the value of the firm will start to decrease and the
WACC will start to increase as more debt is added

84

Direct costs
Legal and administrative costs
Ultimately cause bondholders to incur additional losses
Disincentive to debt financing

Financial distress
Significant problems in meeting debt obligations
Most firms that experience financial distress do not ultimately
file for bankruptcy

85

Indirect bankruptcy costs

Larger than direct costs, but more difficult to measure and
estimate
Stockholders want to avoid a formal bankruptcy filing
Bondholders want to keep existing assets intact so they can at
least receive that money
Assets lose value as management spends time worrying about
avoiding bankruptcy instead of running the business
The firm may also lose sales, experience interrupted operations
and lose valuable employees

86

Case 3 Proposition I

87

Case 3 Proposition II

88

89

It is argued that debt financing can help reduce

agency costs.

For example, debt financing by creating fixed dollar

obligations will reduce the firms discretionary
control over cash and thus reduce wasteful spending.

90

When firms issue new shares, it is perceived that the

firms stock is overpriced and accordingly share price
generally falls. This provides an added incentive for
firms to prefer debt.

91

The major benefit of debt financing is the tax shield provided

by the interest payments.

The costs of debt financing result from:

the increased probability of bankruptcy caused by debt
obligations,
the agency costs resulting from lenders monitoring the firms
actions, and
the costs associated with the firms managers having more
information about the firms prospects than do investors
(asymmetric information).

92

Thus two factors can have material impact on the role

of capital structure in determining firm value and
firms must tradeoff the pluses and minuses of both
these factors:
Interest expense is tax deductible.
Debt makes it more likely that firms will experience
financial distress costs.

93

1.

Higher levels of debt can benefit the firm due to tax

savings and potential to reduce agency costs.

2.

Higher levels of debt increase the probability of

financial distress costs and offset tax and agency cost
benefits of debt.

94

Information asymmetry issues

Signaling Theory
Debt conveys a positive signal
Equity conveys negative signal
Other considerations
Transaction Costs

95

Financing hierarchy
Internal sources of financing
Marketable securities
Debt
Hybrid securities
Equity

96

Value of the firm = marketed claims + nonmarketed claims

Marketed claims are the claims of stockholders and
bondholders
Nonmarketed claims are the claims of the government and
other potential stakeholders
The overall value of the firm is unaffected by changes in
capital structure
The division of value between marketed claims and
nonmarketed claims may be impacted by capital structure
decisions

97

98

Asset composition
Size
Taxation
Profitability
Growth Opportunity
Risk
Industry

99

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