Unit 1 Capital Structure Planning

Capital Structure The mix (or proportion) of a firms permanent long-term financing represented by debt, preferred stock, and common stock equity.

Meaning of Leverage:

leverage refers to the use of fixed costs in an attempt to increase (or lever up) profitability. It represents the impact of one financial variable over some other related financial variable.

Operating leverage The use of fixed operating costs by the firm. Financial leverage The use of fixed financing costs by the firm.

Operating leverage:

Operating leverage is concerned with the operation of any firm. Operating leverage is present anytime a firm has fixed operating costs that must be met regardless of volume.

Fixed operating costs do not vary as volume changes. These costs include such things as depreciation of buildings and equipment, insurance and part of the cost of management. Variable operating costs vary directly with the level of output. These costs include raw materials, direct labour costs, direct selling commissions, and certain parts of general and administrative expenses.

presence of fixed operating costs (operating leverage)-Potential effect is that a change in the volume of sales results in a more than proportionate change in operating profit (or loss).

implies that a relatively small change in sales results in a large change in operating profit. defined as the firms ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes.

A note of caution: leverage is a two-edged sword-just as a companys profits can be magnified, so too can the companys losses. Business risk depends in part on the extent to which a firm builds fixed costs into its operations

A firm sells products for Rs.100 per unit, has variable operating costs of Rs.50 per unit and fixed operating costs of Rs.50,000 per year. Show the various levels of EBIT that would result form sale of 1,000 units 2,000 units and 3,000 units.

If sales level of 2,000 units are used as a base for comparison, the operating leverage is illustrated in the following table: EBIT (Operating profit) for various sales levels
EBIT (Operating profit) for various sales levels

Case I

Base

Case II

-50%
Sales in units Sales revenue 1000 100000 2000 200000

+50%
3000 300000

Less: Variable operating cost

50000

100000

150000

Contribution
Less: Fixed operating cost EBIT

50000
50000 zero

100000
50000 50000

150000
50000 100000

-100%

+100%

Degree of Operating Leverage (DOL):

A quantitative measure of the sensitivity of a firms operating profit to a change in the firms sales.

Degree of operating leverage (DOL) at Q units of output (or sales) =

Percentage change in operating profit (EBIT) Percentage change in output (or sales)

alternative formulas

DOL Q units =

Q (P V) Q(P-V) FC

Q . (Q-QBE)

DOL S Rupees of sales =

S VC S VC- FC

EBIT + FC EBIT

What does DOL 5000 units = 5 really mean?

It means that a 1 percent change in sales form the 5,000 unit sales position causes a 5 percent change in EBIT.

DOL and the Break-Even point: Table: Operating profit and degree of operating leverage at various levels of output (sales) for our example firm
Quantity produced and sold (Q) Operating profit (EBIT) (Rs.) -1,00,000 -75,000 -50,000 -25,000 0 25,000 Degree of Operating leverage (DOL)

0 1,000 2,000 3,000 QBE = 4,000 5,000

0.00 -0.33 -1.00 -3.00 Infinite 5.00

6,000
7,000 8,000

50,000
75,000 1,00,000

3.00
2.33 2.00

We see that the further we move from the firms break-even point, the greater is the absolute value of the firms operating profit or loss and the lower is the relative sensitivity of operating profit to changes in output (sales as measured by DOL. Even firms with large fixed costs will have a low DOL if they operate well above their break-even point. By the same token, a firm with very low fixed costs will have an enormous DOL if it operates close to its break-even point.

How would knowledge of a firms DOL be of use to a financial manager?

The manager would know in advance what impact a potential change in sales would have on operating profit.

DOL and Business risk:

factors giving rise to business risk are variability or uncertainty of sales and production costs The firms degree of operating leverage magnifies the impact of these other factors on the variability of operating profits. The degree of operating leverage should be viewed as a measure of potential risk which becomes active only in the presence of sales and production cost variability.

Financial Leverage:

involves the use of fixed cost financing. The extent to which fixedincome securities (debt and preferred stock) are used in a firms capital structure. Brigham

is concerned with the effects of changes in EBIT on the earnings available to equity shareholders. It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share.

Favourable or positive leverage

is said to occur when the firm uses funds obtained at a fixed cost to earn more than the fixed financing costs paid. Any profits left after meeting fixed financing costs then belong to common shareholders.

Unfavourable or negative leverage

occurs when the firm does not earn as much as the fixed financing costs.

The favourability of financial leverage or trading on equity as it is sometimes called, is judged in terms of the effect that it has on earnings per share to the common shareholders.

It is a double-edged sword. - financial leverage provides the potential of increasing the shareholders earnings as well as creating the risks of loss to them.

The financial manager of the Hypothetical Ltd. expects that its earning before interest and taxes (EBIT) in the current year would amount to Rs. 10,000. The firm has 5 per cent bonds aggregating Rs.40,000, while the 10 per cent preference shares amount to Rs.20,000. What would be the earnings per share (EPS)? Assuming the EBIT being (i) 6,000 and (ii) 14,000, how would the EPS be affected? The firm can be assumed to be in the 35% tax bracket. The number of outstanding ordinary shares is 1,000.

Case I EBIT Less: Interest on bonds Earnings before taxes (EBT) Less: taxes (35%) Earnings after taxes (EAT) Less: Preference dividend Earnings available for ordinary shareholders Earnings per share (EPS) 6,000 2,000 4,000 1,400 2,600 2,000 600

Base 10,000 2,000 8,000 2,800 5,200 2,000 3,200

Case II 14,000 2,000 12,000 4,200 7,800 2,000 5,800

0.6 -81.25%

3.2

5.8 +81.25%

The interpretation of Table is as follows: Case I: A 40 per cent decrease in EBIT (from Rs.10,000 to Rs.6,000) results in 81.25 per cent decrease in EPS (from Rs.3.2 to Rs.0.6). Case II: A 40 per cent increase in EBIT (from Rs.10,000 to Rs.14,000) leads to 81.25 per cent increase in EPS (from Rs.3.2 to Rs.5.8)

Degree of Financial leverage: (DFL)

DFL is a quantitative measure of the sensitivity of a firms earnings per share to a change in the firms operating profit. The degree of financial leverage measures the responsiveness of EPS to the changes in EBIT.

Degree of Financial Leverage (DFL) at EBIT of Rs.X

Percentage change in earnings per share (EPS) Percentage change in operating profit (EBIT) OR

% EPS % EBIT

Or

EPS/ EPS EBIT/ EBIT

EPS can be ascertained as follows: EPS = (EBIT- I)) (1-t) Dp N

Where DFL = Degree of financial leverage EBIT = Earnings before interest and tax t = corporate income-tax rate I = Interest on long-term debt Dp = Preference dividend

DFL EBIT of Rs.X =

EBIT

EBIT I -

Dp (1-t)

Suppose that XYZ Ltd. with long term financing of Rs.10,00,000 consisting entirely of common equity, wishes to raise another Rs.5,00,000 for expansion through one of three possible financing plans. The company may gain additional financing with a new issue of all equity shares all debt at 12 percent interest, or all preference shares with an 11 percent dividend Present annual earnings before interest and taxes (EBIT) are Rs.1,50,000 but with expansion are expected to rise to Rs.2,70,000. The income tax rate is 40 percent, and 20,000 equity shares are now outstanding.

using the debt-financing alternative at Rs.2.7 lakh in EBIT, we have

DFL (EBIT of Rs.2.7 million)= Rs.2,70,000 Rs.2,70,000 Rs.60,000

1.29

For the preference share financing alternative, the degree of financial leverage is DFL EBIT of Rs.2.7 million Rs.2,70,000 Rs.2,70,000 (Rs.55,000/ 0.60) =1.51

although the stated fixed cost involved with the preference share financing alternative is lower than that for the debt alternative (Rs.55,000 versus Rs.60,000), the DFL is greater under the preference share option than under the debt option.

This is because of the tax deductibility of interest and the non-deductibility of preference dividends.

It is often argued that preference share financing is of less risk than debt financing for the issuing firm. With regard to the risk of cash insolvency (inability to pay obligations as they become due), this is probably true. But the DFL tells us that the relative variability of EPS will be greater under the preference share financing arrangement, everything else being equal.

EBIT-EPS Break-Even, or Indifference analysis:

EBIT-EPS break-even analysis: Analysis of the effect of financing alternatives on earnings per share. The break-even point is the EBIT level where EPS is the same for two (or more) alternatives.

Indifference Point: (EBIT-EPS indifference point): The level of EBIT that produces the same level of EPS for two (or more) alternative capital structures.

Suppose that XYZ Ltd. with long term financing of Rs.10,00,000 consisting entirely of common equity, wishes to raise another Rs.5,00,000 for expansion through one of three possible financing plans. The company may gain additional financing with a new issue of all equity shares all debt at 12 percent interest, or all preference shares with an 11 percent dividend Present annual earnings before interest and taxes (EBIT) are Rs.1,50,000 but with expansion are expected to rise to Rs.2,70,000. The income tax rate is 40 percent, and 20,000 equity shares are now outstanding. Equity shares can be sold at Rs.50 per share under the first financing option, which translates into 10,000 additional shares of stock.

Table 3: Calculations of earnings per share under three additional financing alternatives
Equity Equity and Equity and Debt Preference shares 2,70,000 60,000 2,10,000 84,000 1,26,000 1,26,000 20,000 2,70,000 2,70,000 1,08,000 1,62,000 55,000 1,07,000 20,000

Earnings before interest and taxes (EBIT) Interest (I) Earnings before taxes (EBT) Income taxes (EBT X t) Earnings after taxes (EAT) Preference share dividends (Dp) Earnings available to equity shareholders Number of equity shares outstanding

2,70,000 2,70,000 1,08,000 1,62,000 1,62,000 30,000

Earnings per share (EPS)

5.4

6.3

5.35

EBIT-EPS chart: (graphical presentation)

The second data point- is where EPS is zero. This is simply the EBIT necessary to cover all fixed financial costs for a particular financing plan, and it is plotted on the horizontal axis. We can use EPS formula to determine the horizontal axis intercept under each alternative.

Figure 1: EBIT-EPS Break-Even, or Indifference, chart for three additional-financing alternatives

earnings per share indifference point between the debt and equity share additional-financing alternatives is Rs.1.8 lakh in EBIT. If EBIT is below that point, the equity alternative will provide higher earnings per share. Above that point the debt alternative produces higher earnings per share.

The indifference point between the preference shares and the equity share alternative is Rs.2.75lakh in EBIT. Above that point, the preference share alternative produces more favourable earnings per share. Below that point, the equity share alternative leads to higher earnings per share.

Indifference Point determined mathematically:

(EBIT1,2 I1) (1-t) Dp 1= (EBIT1,2 I2) (1-t) Dp2 N1 N2

Fixed Costs: A cost which tends to be unaffected by variations in volume of output. FC depend mainly on the effluxion of time and so not vary directly with volume or rate of output. Variable costs: A cost which tends to vary directly with volume of output. Semi fixed or Semi variable cost: A cost which is partly fixed and partly variable. It should also be segregated into fixed and variable.

Ascertainment of profit under M.C:

Sales VC = Contribution Contribution FC = profit.

Presentation of Marginal cost:

Marginal cost may be presented in a statement form or under break even charts.

Statement forms for presentation

Marginal Cost Statement of a single product: Product A Sales XXXXX Less variable costs XXXX Contribution XXXXX Less: fixed cost Profit XXXX XXXX

Break even analysis

Concerned with the study of revenues and costs in relation to sales volume The determination of that volume of sales at which the firms revenues and total costs will be exactly equal (or net income=zero).

BEP
Determined by two methods
1) Algebraic Methods: a) contribution margin approach and b) Equation technique and 2) Graphic presentation: a) Break-even chart and b) Profit volume graph.

2) Graphic Presentation:

A break-even chart is a device which shows the relationship between sales volume, marginal costs and fixed costs and profit or loss at different levels of activity.

Graphical techniques can be either:

The break-even chart or The profit-volume graph.

Output

40 Rs.

80 Rs. 800 480 400

100 Rs. 1000 600 400

120 Rs. 1200 720 400

200 Rs. 2000 1200 400

Sales

400

Variable 240 cost Fixed cost 400

Total cost

640

880

1000

1120

1600

1600 1400

Profit Volume graph