adv fin mang 2

8/7/2019 adv fin mang 2

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Leverage Issues

Optimal capital structure

Operating leverage Capital structure theory

Capital Structure


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Cost Of Capital ( Theoretical) It is the discount rate that that would

be used to determine the PV of aseries of future cash flows

The minimum rate of return that mustbe earned by the firm on its investment

so that its market value remainsunchanged


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The Concept of Leverage

You cannot easily move a large boulder.


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The Concept of Leverage

However, with the aid of a lever you can

move an object many times your size.


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Uncertainty about future operating income(EBIT), i.e., how well can we predict operatingincome?

Note that business risk does not includefinancing effects.

What is business risk?

Probability

EBITE(EBIT)0

Low risk

High risk


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Business risk is affectedprimarily by:

Uncertainty about demand (sales).

Uncertainty about output prices. Uncertainty about costs.

Product, other types ofliability.

Operating leverage.


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What is operating leverage, and

how does it affect a firmsbusiness risk?

Operating leverage is the use of fixedcosts rather than variable costs.

If most costs are fixed, hence do notdecline when demand falls, then the

firm has high operating leverage.


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More operating leverage leads to morebusiness risk, for then a small sales

decline causes a big profit decline.


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What is financial leverage?

Financial risk?

Financial leverage is the use of debt andstock.

Financial risk is the additional riskconcentrated on common stockholders as

a result of financial leverage.


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The Concept of Leverage In a financial context, the magnifying power

of leverage can be used to help (or hurt) a

firms financial performance. Operating leverage occurs due to fixed

costs in the production process.

With high fixed operating costs, a smallchange in sales will trigger a large changein operating income (EBIT).


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Operating Leverage

Measurement of Operating Leverage Degree of Operating Leverage (DOL)

DOL > 1 means the firm has operatingleverage.

DOL=% Change in EBIT% Change in Sales


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Operating Leverage

DOL=% Change in EBIT% Change in Sales

Example: fixed costs = Rs1 and variable costs=0

EBIT for Sales of Rs3 = Rs3 - Rs1 = Rs2

EBIT for Sales of Rs4 = Rs4 - Rs1 = Rs3

(Rs3 - Rs2)/Rs2 .50(Rs4 - Rs3)/Rs3 .33

DOL = = = 1.5


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DOL DOL = Contrb/ EBIT


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Operating Leverage

Measurement of DOL

Calculation using alternate formula:

DOL= Sales - Total VCSales -Total VC - FC


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Operating Leverage

Measurement of DOL

Calculation using alternate formula:


DOL = (Rs3 - Rs0) / (Rs3 - Rs0 -

Rs1) = 1.5


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Operating Leverage

Measurement of DOL

Calculation using per unit information:


Q = 3,750 unitsSP = Rs 800 per unit

VC = Rs 400 per unit

FC = Rs 1,000,000 per

year.

Example:Example:


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Operating Leverage

Measurement of DOL

Calculation using per unit information:

DOL3,750 units =

= 3

3,750(800) 3,750(400)3,750(800) 3,750(400) 1,000,000

DOL= Sales - Total VCSales-Total VC - FC

Interpretation: If sales change 1%, then

EBIT will change 3% (same direction).


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What is financial leverage?

Financial risk?

Financial leverage is the use of debt inplace of equity

Financial risk is the additional risk

concentrated on common stockholdersas a result of financial leverage.


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Financial leverage ratio definition

and explanation:

The financial leverage ratio is also

referred to as the debt to equity

ratio.

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The financial leverage ratio indicates theextent to which the business relies on debt

financing. Upper acceptable limit of the financial

leverage ratio is usually 2:1, with no morethan one-third of debt in long term.

A high financial leverage ratio indicatespossible difficulty in paying interest andprincipal while obtaining more funding.

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What Does Degree Of Financial

Leverage -DFL Mean?

A leverage ratio summarizing theaffect a particular amount of financialleverage has on a company's earnings

per share (EPS).

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Financial leverage involves using fixedcosts to finance the firm, and will

include higher expenses beforeinterest and taxes (EBIT). The higherthe degree of financial leverage, the

more volatile EPS will be, all otherthings remaining the same. Theformula is as follows:

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Financial Leverage Degree of Financial Leverage Finance a portion of the firms assets with

securities that have fixed financial costs

Debt Preferred Stock

Financial Leverage measures changes inearnings per share as EBIT changes.

DFLEBIT =% Change in NI

% Change in EBIT

Base Level of EBIT


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Degree of Financial LeverageDegree of Financial Leverage measures the amount of risk

a company takes up when it borrows more debt (andincreases the debt portionof its capital structure). The formula for Degree ofFinancial Leverage is:

Degree of Financial

Leverage

Earnings Before Interest & Taxes (EBIT)

Earnings Before Taxes (EBT)


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Financial Leverage

EBIT = Rs500,000

Interest Charges = Rs200,000

Example:

DFLEBIT=500,000 =500,000

500,000 200,000

= 1.67 times

Interpretation:When EBIT changes 1% (from

an existing level of Rs500,000) Net Income

will change 1.67% in the same direction.

The formula is as follows:


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Financial LeverageEBIT = Rs500,000

Interest Charges = Rs200,000

Example:

DFLEBIT=500,000 =500,000

500,000 200,000

= 1.67 times

Interpretation:When EBIT changes 1% (from

an existing level of Rs500,000) Net Income

will change 1.67% in the same direction.


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To illustrate Degree of Financial Leverage,lets do a hypothetical question

. Imagine there are 3 firms, Firm A, Firm Band Firm C. Each one has an interest

expense of $12000 in the year 2006. TheEarnings Before Taxes for each firm is givenbelow in the table. Can you calculate theDegree of Financial Leverage using this

data? Interest Expense = $80,000 x 15% = $12000

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Firm A Firm B Firm C

EBIT 25000 50000 75000


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Firm A Firm B Firm C

EBIT 25000 50000 75000

EBT (EBIT -

Interest

Expense)

25000 -

12000

= 13000

50000 -

12000

= 38000

75000 -

12000

= 63000

Degree of

FinancialLeverage

(EBIT /

EBT)

25000 /13000

= 1.92

50000 /38000

= 1.32

75000 /63000

= 1.19


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Future returns based onprobability

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A practical illustration

Supposing elections are to be held in a short

time and an analyst pictures the followingthree scenarios

1) Scenario 1 with a probability of 025%

A stable government with majority ruleA rate of return is forecasted to be around

36%


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2) Scenario 2 with a probability of

0.50%

A coalition government lasting its

full term.

A rate of return is forecasted to be

around 26%


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3) Scenario 3 with a probability of

0.25%

Re-elections in the immediate

future.

A rate of return is forecasted to be

around 12%


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This three scenarios will coverallpossible situations and hence the

total of all the probabilities will be 1meaning there cannot be anotherpossible situation.

We put the information in the form of atable


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Scenario Probability ExpectedReturn

1 0.25 36%

2 0.50 26%

3 0.25 12%


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Now an investor will ask a very simplequestion considering all the possible

situations and values involved whatwould be my average expected

return?


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The expected average return is nothingbut the weighted average return of all

the returns and where the weights arethe respective probabilities.


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Scenario Probability ExpectedReturn

Average

1 0.25 36% (.25*36) =9

2 0.50 26% (.50*26)=13

3 0.25 12% (.25*12)=3

9+13+3=25%


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Given a probability distribution of returns, the expected returncan be calculated using the following equation:

where

E[R] = the expected return on the stock,

N = the number of states,

pi = the probability of state i, and

Ri = the return on the stock in state i.

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Risk

Given an asset's expected return, itsvariance can be calculated using the

following equation:

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where

N = the number of states,

pi = the probability of state i,

Ri = the return on the stock in state i,and

E[R] = the expected return on thestock.

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The standard deviation is calculated asthe positive square root of the

variance.

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Indifference EBIT Example

ABC Corp. currently has 200,000shares outstanding on the stock market

with the current price being $20. TheBoard of Directors of the Corp want toincur a debt of $1 million by issuing junk

bonds that have a coupon interest rateof 9% annually. At what point of EBITwould the Corp. be indifferent to havingdebt or NO debt?

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Current Capital Structure = $20 x200,000 shares = $4,000,000 Equity

New Capital Structure = $3,000,000Equity & $1,000,000 Debt

- Current Stock Price Remains at $20.

- To attain $3,000,000 of Equity, the # ofshares = 150,000.

Annual Interest Expense Coupon

Payments = 9% x 1,000,000 = $90,000S N Tara 55


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No Debt With Debt

Indifference EBITEBIT - 0

200,000

= EBIT - 90,000

150,000

Indifference EBIT

150,000 EBIT = 200,000 (EBIT - 90,000)

150,000 EBIT = 200000EBIT - 18000000000

18000000000= 200,000 EBIT - 150,000 EBIT18000000000= 50,000 EBIT

EBIT = 18000000000 / 50,000

EBIT = $360,000


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Interpretation of EBIT

At a point where Earnings Before

Interest & Taxes is $360,000, ABCCorp. will not care whether it has anyoutstanding debt issues, NO debt or a

combination of both because at thispoint, the value of the Capital Structureis NOT affected.

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Why does the bond rating and

cost of debt depend upon theamount borrowed?

As the firm borrows more money, thefirm increases its risk causing the

firms bond rating to decrease, and its

cost of debt to increase.


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Other factors to consider when

establishing the firms targetcapital structure?

1. Industry average debt ratio

2. TIE ratios under different scenarios3. Lender/rating agency attitudes

4. Reserve borrowing capacity

5. Effects of financing on control6. Asset structure

7. Expected tax rate


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Financial Leverage of Ten Largest Indian

Companies, 2006

Company Capital Gearing Income Gearing

Debt ratio Debtequity ratio Interest coverage Interest to EBIT ratio

1. Indian Oil 0.556 1.25:1 4.00 0.250

2. HPCL 0.350 0.54:1 5.15 0.194

3. BPCL 0.490 0.96:1 5.38 0.186

4. SAIL 0.858 6.00:1 - ve - ve

5. ONGC 0.106 0.12:1 53.49 0.019

6. TELCO 0.484 0.94:1 0.99 1.007

7. TISCO 0.577 1.37:1 1.62 0.616

8. BHEL 0.132 0.15:1 8.36 0.120

9. Reliance 0.430 0.75:1 3.46 0.289

10. L&T 0.522 1.09:1 2.31 0.433

11. HLL 0.027 0.03:1 264.92 0.004

12. Infosys 0.000 0.00:1 NA* NA*

13. Voltas 0.430 0.72:1 2.64 0.378


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Three commonly used ratios for

analyzing leverage are debt to assets,

long term debt to equity and timesinterest earned. These ratios should

be of interest to both creditors andmembers.

Note


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Times interest earned (TIE) is

calculated by dividing earnings beforeinterest and taxes by interest

payments. Creditors want to know if

the organisations operations generate

enough margins to cover the interestpayments.


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Long-term Debt Ratios for

Selected Industries

Industry Long-Term Debt RatioPharmaceuticals 20.00%Computers 25.93Steel 39.76Aerospace 43.18Airlines 56.33

Utilities 56.52

Source: Dow Jones News Retrieval. Datacollected through December 17, 1999.


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net earnings:

Gross sales minus taxes, interest,depreciation, and other expenses.Net earnings are one of the most importantmeasures of a company's

performance, since the pursuit of earnings isthe primary reasoncompanies exist. Sometimes net earningsincludes one-time and

extraordinary items, and sometimes it doesnot. also called netearnings or net income orbottom line.

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