LN12 Keown33019306 08 LN12 GE

Chapter 12
Financial Leverage
and Capital
Structure Policy
Learning Objectives
1. Distinguish between business and financial risk.

2. Use break-even analysis.
3. Understand the relationship between operating,
financial, and combined leverage.
4. Discuss the concept of an optimal capital
structure.
5. Use the basic tools of capital structure
management.
Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-2

Figure 12-1

UNDERSTANDING THE DIFFERENCE
BETWEEN BUSINESS AND
FINANCIAL RISK

Risk
• Risk is 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 a 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:
– The stability of the domestic economy
– The exposure to, and stability of, foreign
economies
– Sensitivity to the business cycle
– Competitive pressures in the firm’s industry

Operating Risk
• Operating risk is the variation in the firm’s

operating earnings that results from 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 firm’s financing mix or
proportion of financing that requires a fixed
return.

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

manager to
• determine the quantity of output that must
be sold to cover all operating
costs, as distinct from financial costs.
• calculate the EBIT that will be
achieved at various output levels.

Essential Elements of
the Break-Even Model
• Break-even analysis requires information on
the following:
– Fixed Costs
– Variable Costs
– Total Revenue
– Total Volume

Essential Elements of
the Break-Even Model
• 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,
break-even 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.

Fixed Costs Examples
1. Administrative salaries
2. Depreciation
3. Insurance
4. Lump sums spent on intermittent advertising
programs
5. Property taxes
6. Rent

Variable or Direct Costs
• Variable costs vary as output changes. Thus

if production is increased by 5%, total
variable costs will also increase
by 5%.

Variable Costs Examples
1. Direct labor
2. Direct materials
3. Energy costs (fuel, electricity, natural gas)
associated with the production
4. Freight costs
5. Packaging
6. Sales commissions

The Behavior of Costs

Semivariable Costs

Revenue
• Total revenue is the total sales dollars.

• Total revenue = P  Q
P = selling price per unit
Q = quantity sold

Volume
• The volume of output refers to the

firm’s level of operations and may be
indicated either as a unit quantity or as
sales dollars.

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)]

Break-Even Point (BEP)

Example
• Selling price = $12 per unit

Variable cost = $6 per unit
Fixed costs = $120,000
• BEP (units) = $120,000/ ($12 – $6)
= $120,000/$6
= 20,000 units
• If the firm sells 20,000 units, EBIT will be
equal to zero dollars.

Example
• At sales of $240,000, EBIT will be equal to

zero dollars.

Table 12-1

Example
• Selling price = $10 per unit

• Variable cost = $6 per unit
• Fixed cost = $100,000

Example
• (1 – 180,000/300,000) = 1 – 0.6 = 0.4

SOURCES OF OPERATING
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
• Thus % change in EBIT

= OL  % 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 (OL) of 6, then what is the change in
EBIT if sales increase by 5%?
% change in EBIT = OL  % change in sales

= 5%  6 = 30%
• Thus, if the firm increases sales by 5%, EBIT
will increase by 30%

Operating Leverage
• Operating leverage is present when

% change in EBIT / % change in sales is
> 1.00
• The greater the firm’s degree of operating

leverage, the more the profits will vary in
response to change in sales.

Table 12-2

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 drop 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%.

Table 12-3

Financial Leverage
• Financial leverage means financing a portion

of the firm’s assets with securities bearing a
fixed (limited) 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 the firm’s
use of financial leverage.

Three Capital Structure Plans

Three Capital Structure Plans
• 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.

Impact of Capital Structure Plans
on EPS

Impact of Capital Structure Plans
on EPS (cont.)

Capital Structure Plans
• A firm employing financial leverage is

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
 Financial Leverage
• See Table 12-6

Leverage and Earnings

The Combined Leverage Effect

Combining Operating and
Financial Leverage
• Table 12-6 shows that a modest 20%

increase in sales revenue translates to
150% increase in EPS due to the combined
leverage effect.

CAPITAL STRUCTURE
THEORY

Financial & Capital Structure
• Financial Structure
– Mix of all items that appear on the right-hand
side of the company’s balance sheet (see Table
12-7).
• Capital Structure
– Mix of the long-term sources of funds used by
the firm
– Capital Structure = Financial Structure – Non-
interest- bearing liabilities (accounts payable,
accrued expenses)

Financial & Capital Structure

Designing a Capital Structure
• Designing a prudent capital structure

requires answers to the following:
• Debt maturity composition: How should a
firm best divide its total fund sources
between short-term and long-term debt
components?
• Debt-equity composition: What mix of debt
and equity should the firm use?

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 fund sources is called the
“optimal capital structure.”

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 so as to maximize
shareholder’s wealth.

Independence Position
• According to Modigliani & Miller, the total

value of the firm is not 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, capital
structure consisting of only stocks and
bonds, perfect or efficient markets).

• Figure 12-5 shows that the firm’s value

remains the same, despite the differences in
financing mix.
• Figure 12-6 shows that the firm’s cost of
capital remains constant, although cost of
equity rises with increased leverage.

Firm Value and
Capital Structure

Financial Leverage and
Capital Costs

• The implication of these figures for financial
managers is that one capital structure is just
as good as any other.
• However, the above conclusion is possible
only under strict assumptions.
• We next turn to a market and legal
environment that relaxes these restrictive
assumptions.

Extensions to Independence
Hypothesis: The Moderate Position
• The moderate position considers how the

capital structure decision is affected when
we consider:
– Interest expense is tax deductible (a benefit of
debt)
– Debt financing increases the risk of default (a
disadvantage of debt)
• Combining the above (benefit & drawback)
provides a conceptual basis for designing a
prudent capital structure.

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

Table 12-8

Impact of Taxes on
Capital Structure
• Since interest on debt is tax deductible, the

higher the interest expense, the lower the
taxes.
• Thus, one could 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?

Impact of Taxes on
Capital Structure
• One possible explanation is:
Bankruptcy 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) increase 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 always lead to a
higher value … after a point, debt reduces
the value of the firm to shareholders.
• This explains a firm’s tendency to restrain
itself 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).

Capital Costs and
Financial Leverage

Firm Value and 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
Structure
• Capital structure management also gives rise to
agency costs. Bondholders are principals, as
essentially they have given a loan to the
corporation, which 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.

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 type of
project that management can undertake, collateral,
distribution of dividends, limits on further
borrowing).
• Agency costs depend on the level of debt. At lower
levels of debt, creditors may not insist on a long list
of bond covenants to monitor. Thus, agency cost
and cost of financing are reduced at lower levels of
debt.

Structure
• 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).

The Agency Costs of Debt

Managerial Implications
• Determining the firm’s financing mix is

critically important for the manager.
• We observe that the decision to maximize the

market value of leveraged firm is influenced
primarily by the present value of tax shield
benefits, present value of bankruptcy costs,
and present value of agency costs.

THE BASIC TOOLS OF
CAPITAL STRUCTURE
MANAGEMENT

The Basic Tools of Capital
Structure Management
• Two basic tools used to evaluate capital

structure decisions are:
– EBIT-EPS analysis
– Financial leverage ratios

EBIT-EPS Analysis
• Managers care about EPS, as it sends an

important signal to the market about future
prospects and will affect the stock prices.
• The EBIT-EPS chart provides a way to
visualize the effects of alternative capital
structure on both the level and volatility of
the firm’s earning per share (EPS).

EBIT-EPS Chart

EBIT-EPS Chart
• The chart shows that at a specific level of EBIT,

stock and bond plan produce different EPS (except
at the intersection point with EBIT = $21,000 where
EPS is equal to $4.25 under both plans).
• Above the intersection point, EPS will be higher for
plan with greater leverage (and vice versa).
• For example, at EBIT of $30,000
– EPS using bond plan = $7.25
– EPS using stock plan = $6.50

Finding the Intersection or EBIT-
EPS Indifference Point
• Compare EPS-stock plan versus EPS-bond

plan and solve for EBIT in the following
two equations:
• (EBIT-I)(1-t)-P = (EBIT-I)(1-t)-P
Ss Sb
Ss = # of stocks under stock plan
Sb = # of stocks under bond plan
I = interest expense
P = preferred dividends
t = tax rate
Finding the Intersection or EBIT-
EPS Indifference Point
• EPS-EBIT chart is simply a tool to analyze

capital structure decision.
• Thus, achieving a high EPS based on high

leverage may not be the right decision.
• The final decision will be made after

weighing all factors.

Table 12-9

Comparative Leverage Ratios
• Two types of ratios (as covered in Chapter

4), balance sheet leverage ratios and
coverage ratios, can be computed and
compared to industry norms.
• If the ratios are significantly different from
industry average, the managers must
analyze further.

Capital Structure Determinants
(Survey Results)
A survey of 392 corporate executives revealed the
following ten factors as important determinants of
capital structure decision:
Financial flexibility:
Firm’s bargaining position is stronger 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.

(Survey Results) (cont.)
Insufficient internal funds:
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:
Debt is cheaper due to the tax benefit on interest paid.
Dividend distribution does not receive any tax benefit.

Transaction costs and fees:
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. Thus, valuation impacts the timing of security
issue.
Comparable firm debt levels:
Firms from similar businesses tend to have similar capital
structures.

Bankruptcy/distress costs:
Higher level of existing debt will increase the
likelihood of financial distress.
Customer/supplier discomfort:
High levels of debt will increase discomfort among
customer (fearing disruption in supply) and
suppliers (fearing disruption in demand and
late/non- payment on existing contracts).

Key Terms
• Balance sheet leverage ratios

• Break-even quantity
• Business risk
• Capital structure
• Combined or total leverage
• Coverage ratios
• Debt capacity
• Debt-equity composition
• Debt maturity composition
• Direct costs
• EBIT-EPS indifference point
• Financial leverage
• Financial risk

Key Terms
• Financial structure
• Fixed costs
• Indirect costs
• Operating risk
• Operating leverage
• Optimal capital structure
• Optimal range of financial leverage
• Tax shield
• Total revenue
• Variable costs
• Volume of output

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Chapter 12

1. Distinguish between business and financial risk.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-2

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-3

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-4

• Risk is variability associated with expected

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-5

• Business risk is the variation in the firm’s

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-6

• Operating risk is the variation in the firm’s

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-7

• Financial risk is the variation in earnings as

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-8

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-9

• Break-even analysis is used to determine

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-10

Use of break-even model enables the financial

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-11

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-12

• Break-even analysis requires classification of

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• These costs do not vary in total amount as

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-14

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-15

• Variable costs vary as output changes. Thus

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-16

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• Total revenue is the total sales dollars.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-20

• The volume of output refers to the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-21

• BEP = Point at which EBIT equals zero

+ (total fixed cost)]

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Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-23

• Selling price = $12 per unit

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• At sales of $240,000, EBIT will be equal to

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• Selling price = $10 per unit

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• (1 – 180,000/300,000) = 1 – 0.6 = 0.4

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Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-29

• Operating leverage measures the sensitivity

• If the firm has no fixed operating costs,

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• Thus % change in EBIT

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• Example : If a company has an operating

% change in EBIT = OL  % change in sales

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• Operating leverage is present when

• The greater the firm’s degree of operating

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-33

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-34