FINANCIAL MANAGEMENT

LEVERAGE AND
LONG-TERM
FINANCE
BY GROUP 9

LECTURER:MRS.HUYNH THI CAM HA

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 PART 1
LEVERAGE
1.1 LEVERAGE.
DEFINITION
Leverage is the impact that fixed costs have on shareholder
after-tax returns. Fixed operating costs, such as a firm's
equipment costs or financial costs, such as loan repayments,
amplify their risks and returns. A high-leverage firm has much
higher returns, but with higher volatility.
 TYPES OF LEVERAGE
OPERATING LEVERAGE

FINANCIAL LEVERAGE

TOTAL LEVERAGE
 OPERATING LEVERAGE
The relationship between a firm's sales revenue and its
FOCUS:
Earnings Before Interest and Taxes (EBIT).

MECHANISM:

Companies that have high fixed operating costs show large

changes in EBIT for comparatively small changes in sales.

EFFECT:

Companies can control operating leverage by changing the

relationship between fixed costs - for example, making products
internally - and variable costs - for example, outsourcing
production. It affects the break-even point and risk levels.
 FINANCIAL LEVERAGE
The relationship between EBIT and Earnings Per Share
FOCUS:
(EPS).

MECHANISM:

Fixed financial costs, like interest payments or preferred dividends,

magnify changes in EBIT, leading to greater proportional changes in
EPS.

EFFECT:

Highly financially leveraged firms face the risk of increasing financial

burdens.
TOTAL LEVERAGE
Combines
MECHANISM: effects of operating and financial
leverage.
Total leverage refers to the relationship
between sales revenue and EPS. It reflects the
overall responsiveness of EPS to changes in
sales.
 BREAKEVEN ANALYSIS
Breakeven analysis determines what volume of operations is needed to break even-to cover all
DEFINITION
costs. It is useful in assessing the profitability associated with various levels of sales.

KEY CONCEPTS: BREAKEVEN POINT FORMULA:

Where:
Fixed costs (such as rent) remain the Q = quantity sold
same even if sales increase.
FC
Q = FC = fixed costs
Variable costs vary depending on the (P-VC) P = price per unit
number of goods sold. VC = variable cost
per unit.
 OPERATING LEVERAGE IN
PRACTICE
Operating leverage occurs when a firm's fixed operating costs result in disproportionately
large percentage changes in EBIT relative to the corresponding change in sales. Operating
leverage is calculated by what is called the Degree of Operating Leverage or DOL, which is
computed as:

PERCENTAGE CHANGE IN SALES

DOL =
PERCENTAGE CHANGE IN EBIT​
 1.2 THE FIRM'S
DEFINITION
The mix of debt and
equity financing a firm

CAPITAL STRUCTURE
uses. This mix affects
directly a firm's risk,
cost of capital and
overall value.

Comprises long-term debt such as bonds or loans.

Debt Capital Has lower cost because of the tax deductibility of the
interest.
CAPITAL Nevertheless, it increases financial risk owing to
STRUCTURE obligatory interest payments.
COMPONENTS

It includes preferred stock, common stock, and

Equity Capital retained earnings.
Common stockholders bear the highest risk and
require the highest returns.
Generally, equity is costlier than debt due to its risk
premium.
 RISK

FACTORS AFFECTING
High debt levels
(financial leverage)
increase financial risk,

CAPITAL STRUCTURE
especially if the firm
cannot meet interest
obligations.

COST OF
CAPITAL CAPITAL
STRUCTURE A balanced capital
INDUSTRY structure minimizes
NORMS the overall cost of
Debt levels tolerated
capital, optimizing
vary among
project acceptability
industries, based on
and firm value.
operational stability
and type of assets
 EXTERNAL EVALUATION
TOTAL LIABILITIES TIMES INTEREST EBIT
DEBT RATIO = =
TOTAL ASSETS EARNED INTEREST EXPENSE

FIXED-PAYMENT COVERAGE
:
ENTITY'S ABILITY TO COVER
FIXED FINANCIAL PAYMENTS
 INTERNATIONAL COMPARISON
OF CAPITAL STRUCTURE
The non U.S. Firms seem to rely on more debt than U.S. Firms because:
Less developed capital markets.
Greater reliance on commercial banks for financing.
Tightly controlled ownership structures in many countries, facilitating higher debt
tolerance.
 SUMMARY OF IMPACTS
THE CHOSEN CAPITAL STRUCTURE
The chosen capital structure balances return and risk. Effective decisions
reduce the cost of capital and enhance the firm's value, whereas poor
decisions can increase costs and risk.
 1.3.OPERATING
LEVERAGE
Definition:
Operating leverage arises from the use of fixed operating
costs, which magnify the impact of changes in sales on a
firm’s earnings before interest and taxes (EBIT)
KEY POINTS:
CONCEPT OF OPERATING LEVERAGE:
When fixed costs are significant, small
changes in sales can lead to large
changes in profitability.
High operating leverage means greater
potential rewards but also higher risks if
sales decline.

BREAKEVEN ANALYSIS:
The breakeven point is where revenue
equals total costs, and EBIT is zero. Beyond
this point, profits rise sharply with
increased sales.
Firms with higher fixed costs reach
breakeven slower but experience larger
profit increases after surpassing it.
KEY POINTS:
APPLICATIONS AND RISKS:

Stable industries with predictable

revenues (e.g., utilities) benefit from high
operating leverage.
In volatile industries, high fixed costs can
lead to significant losses during
downturns.
1.4.FINANCIAL LEVERAGE
Definition: Financial leverage is the use of fixed
financial costs, such as debt interest or preferred
dividends, to amplify changes in earnings before
interest and taxes (EBIT) on earnings per share
(EPS).
KEY POINTS:
CONCEPT OF FINANCIAL LEVERAGE:
Financial leverage enhances shareholder
returns during periods of growth but
increases bankruptcy risk during downturns.

EFFECTS ON EARNINGS:
Higher levels of debt lead to greater
volatility in EPS, as financial costs must be
paid regardless of the firm’s earnings.
A firm’s financial structure directly affects
its risk and ability to meet fixed
obligations.
COMBINING OPERATING AND FINANCIAL
LEVERAGE:
Total leverage represents the combined
effect of operating and financial leverage.
High total leverage magnifies both
potential gains and losses, making it
crucial for firms to manage their fixed
costs carefully.
 SUMMARY
Operating leverage focuses on fixed operating costs and their impact on
EBIT, while financial leverage deals with fixed financial costs and their
influence on EPS.
Together, they form total leverage, which significantly affects a firm’s
profitability and risk profile. Effective management of leverage is essential
2.
to balance growth potential and financial stability.
 PART 2
LONG-TERM FINANCE
 2.1.
COMMON STOCKS
VS.
PREFERRED STOCKS
COMMON STOCKS
Common stock typically has no special
preference in dividends or bankruptcy.
Shareholders have the right to elect
directors, who then hire management.
However, stocks play a crucial role in the corporate, by
applying “one share, one vote” – those holding the
most number of shares can become the head of
Board of Directors (BOD) and can decide most of the
enterprise’s operating activities.
The BOD election must be re-approached each year
in the annual shareholders’ meeting that those who
are entitled to vote must vote to elect the members in
the BOD. There are two types of voting: cumulative
voting and straight voting.
 Cumulative voting Straight voting

Voting Mechanisms shareholders to allocate votes across Shareholders cast one vote per
multiple candidates. share for each candidate.

Enables minority shareholders to Allows minority shareholders to

Voting Power choose their preferred candidates. select their favored candidates.

Votes can be concentrated on a Votes are spread equally

across candidates.
Vote Allocation single candidate.

Simpler and more

More complex in vote
Complexity straightforward.
distribution.

Less common, used for specific More common in standard

Common Use governance structures. corporate governance.

Percentage of shares (V/N-1 )% + 1 share 50% shares + 1 share

required to secure a
seat:
OTHER CONCEPTS
PROXY VOTING:
A proxy is the grant of authority by a shareholder to
someone else to vote her shares. For convenience, much
of the voting in large public corporations is actually done
by proxy.

OTHER SHAREHOLDER RIGHTS:

Shareholders have the right to share proportionally in

dividends, assets after liquidation, and vote on
significant matters like mergers.
Some corporations offer preemptive rights, allowing
existing shareholders to buy new stock before the
general public to maintain their ownership percentage
 DIVIDENDS
Dividends is not a liability of the corporation
until declared and are paid at the discretion
of the board of directors.

Dividends are paid from after-tax cash flow

and are not tax-deductible for the corporation

Dividends are taxable : Individual shareholders

are taxed on dividends, but corporations can
exclude a portion of dividends received from other
corporations from their taxable income.
PREFERRED STOCK
Preferred stock pays a cash dividend
expressed in terms of dollars per share.
Preferred stock pays a fixed cash dividend
and has preference over common stock
in dividends and liquidation.
Preferred stock is a form of equity from a
legal and tax standpoint. However, it
usually has no voting rights and no
maturity date.
 STATED VALUE
Each preferred stock has a stated liquidating value, often referred to as the
stated value. This indicates the amount the company must pay to shareholders
for each share of preferred stock they own, similar to how bonds represent value.
However, there are some key differences between preferred stock and bonds:

Dividends on preferred stock can be cumulative or noncumulative,

with cumulative dividends being carried forward if not paid.

Stock can be seen as debt due to its fixed dividends and credit
ratings, and it is sometimes convertible into common stock or
callable by the issuer.

Some stocks have sinking funds, requiring the company to retire a

portion of the stock each year.
 2.2.
CORPORATE LONG-
TERM DEBT:
CREDITORS AND DEBTORS
The person or firm making the loan is called the creditor or lender.
The corporation borrowing the money is called the debtor or borrower.
Corporations issue securities classified as either equity or debt.

THE MAIN DIFFERENCE BETWEEN EQUITY AND DEBT

Debt does not confer ownership or voting rights.
Interest on debt is tax-deductible, while dividends on equity are not.
Unpaid debt is a liability and can lead to bankruptcy, unlike equity.
EQUITY VS DEBT

SOURCES: CORPORATE FINANCE 12TH EDITION

LONG-TERM DEBT: THE BASICS
Long-term debt involves promises to pay principal
and interest.
Maturity refers to the length of time the debt
remains outstanding.
Debt securities include notes, debentures, and
bonds, with bonds typically being secured debt.
Publicly (standardized) or Privately (negotiable)

! KEY FEATURES
Security, call features, sinking funds, ratings,
and protective covenants.
 THE INDENTURE
The indenture is a legal agreement between the
corporation and its creditors. It includes terms of the
bonds, security description, seniority, repayment
arrangements, call provisions, and protective
covenants.

A trustee ensures compliance with the indenture

terms and represents bondholders in case of default.
 2.3. SOME DIFFERENT TYPES OF BONDS
FLOATING-RATE BONDS

These bonds have adjustable coupon payments tied to an interest

rate index like the Treasury bill rate or LIBOR.

The coupon rate adjusts with a lag to a base rate and often has
a floor and ceiling, known as a "collar".

They may include a put provision, allowing the holder to redeem the
bond at par on the coupon payment date after a specified time.
 SOME DIFFERENT TYPES OF BONDS
OTHER TYPES OF BONDS:

BONDS
INCOME CONVERTIBLE
WITH
BONDS BONDS
WARRANTS

COCO BONDS
PUT EXOTIC
BONDS BONDS
NONO BONDS
2.4.BANK LOANS SYNDICATED LOANS:

Large banks may arrange a syndicated loan

Firms can borrow from banks instead of
issuing bonds. with a firm or country and sell portions of it to

Two important features of bank loans are a syndicate of other banks.

lines of credit and syndication. Each bank in the syndicate has a separate

LINES OF CREDIT: loan agreement with the borrower.

The syndicate includes a lead arranger and
Banks provide a business with a line of credit,
participant lenders. The lead arranger
setting a maximum amount the bank is
negotiates the loan and receives an up-front
willing to lend.
fee.
The business can borrow money as needed,
Syndicated loans can be publicly traded and
and if the bank is legally obligated, it is called
a revolving line of credit or revolver. are usually rated investment grade, but

A commitment fee is charged on the unused leveraged syndicated loans are rated

portion of the revolver speculative grade (junk).

 2.5.INTERNATIONAL BONDS
FEATURE EUROBOND FOREIGN BONDS
ISSUING
Issued outside the issuer's home country Issued in a single country
COUNTRY

CURRENCY Denominated in a single currency, typically the Denominated in the currency of the country
DENOMINATION issuer's home currency where the bond is issued

Primarily syndicated and traded internationally, Issued and traded in the domestic market of the
MARKET country
often in London

Fewer restrictions compared to domestic Subject to the regulatory and legal restrictions
RESTRICTIONS
offerings of the issuing country

TAX LAWS May be subject to more favorable or fewer tax Often subject to the tax laws and regulations of
laws compared to domestic bonds the issuing country

DISCLOSURE Generally less stringent than for domestic bonds Tighter disclosure requirements, often more
REQUIREMENTS stringent than Eurobonds
 FIRM OBJECTIVE
Firms want to invest in projects with positive NPV.

2.6.PATTERNS OF Sources of Funds to Finance

Positive NPV Projects

FINANCING
INTERNAL FINANCING EXTERNAL FINANCING
(Cash Flow from Firm) (Debt and Equity)

Net Income + Depreciation - Dividends

Fund both capital 2 sources of cash flow,
spending and internal and external
investment in net financing.
working capital. > Stocks and bonds
must be issued to fill
the financial deficit.

FIGURE 15.1
 Financing
F
I Decision by US
G
U
R
Nonfinancial
E
15.2
Corporation

Net stock buybacks:

accelerated from 2002 to 2007.
-> flush with cash => found
Internally generated cash flow (dominant source)
stock repurchases more
increased over the sample period, exceeding 100%
attractive than dividend
-> Negative external financing-> Redeem > Issuing
payments.
2.7.RECENT TRENDS IN CAPITAL STRUCTURE

Figure 15.2 indicates that, since 1995, U.S. firms tended to issue debt while retiring stock

Figure 15.3 shows that the ratio was actually lower in 2010 than it was in 1995 -> As long as net income exceeds
dividends => retained earnings will be positive => raising the book value of equity.
RECENT TRENDS IN CAPITAL STRUCTURE

The ratio has also fallen slightly over the 15 years <-> movements in the stock market affect market values
of individual firms.

Taken together, both figures suggest that the ratio of debt to equity has changed little.
 BOOK OR MARKET VALUES?
FINANCIAL
MARKET VALUES
ECONOMISTS
1. Market prices reflect current
information.
2. The use of market values
contrasts with the perspective
of many corporate
DEBT RATIOS HAVE
practitioners.
BEEN WELL BELOW
VOLATILITY OF THE
BOOK VALUES 100% OF TOTAL EQUITY
STOCK MARKET
IN RECENT YEARS
-> FIRMS GENERALLY
USE LESS DEBT THAN
EQUITY.
THANK YOU
FOR ATTENTION
GROUP 9