3.1 Lecture_05_Mon_27th_July_2009

3.1 Lecture_05_Mon_27th_July_2009 - FINC 202 2009 Lecture...

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Unformatted text preview: FINC 202 2009 Lecture 05 Risk & Return, and how these relate to Capital Structure 1 Concepts of Leverage (1) Booming economy: • The greater the leverage, the greater the ROE Better to think in terms of increased Cash flows to equity Recession economy: • The greater the leverage, the worse the ROE Better to think in terms of diminished ____________________________ 2 Concepts of Leverage (2) If we reduce or hold the rate of Variable Costs of production constant and increase the level of fixed costs, what happens? This is Operating Leverage If we hold the level of Owner’s Equity in the capital structure constant and increase the level of debt, what happens? This is ____________________________ 3 The more volatile EBIT is likely to be: • The lower the level of acceptable leverage Operating leverage Financial leverage • EBIT volatility is BUSINESS RISK. The more volatile market interest rates are • The lower the level of acceptable leverage • High rd and high wd = _______________________________ 4 Business risk is affected primarily by: Uncertainty about demand (sales) Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. _________________________ Business risk defined business risk induced by firm’s investment decision business risk influenced by • • • • • demand variability sales price variability input price variability firm’s control over margin rate of technological change • presence of _____________________ 6 What is operating leverage, and how does it What affect a firm’s business risk? affect Operating leverage is the use of fixed costs rather than variable costs. If most costs are fixed, hence do not decline when demand falls, then the firm has ____________________________ Operating Leverage EBIT = PQ – VQ ­ F at QBE EBIT = 0 F QBE = P−V high Fixed cost & low Variable cost leads to: • ______________________________ 8 More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. $ Rev. TC $ Rev. EBIT TC FC FC QBE Sales QBE Sales What happens if variable costs change? Probability Low operating leverage High operating leverage EBITL EBITH Typical situation: Can use operating leverage to get higher _______________________________ Financial Leverage and Capital Structure Aim of management is to maximise share price • Achieved by maximising Net After Tax Cash Flow (ATCF) from TA • Leverage increases TA without increasing Equity • Therefore ___________________________ How does this work? • TA ⇑ will cause the ATCF ⇑ to be shared by same old number of shares in hands of shareholders (ie, ∆ N = 0) 11 ATCF = After Tax Cash Flows = NPAT + Depreciation Financial risk defined Financial Financial risk induced by firm’s financing decision • The weighting of debt (and hybrids) in the capital structure Financial risk associated with use of interest­ bearing debt • • term loans Bonds • _________________________________ 12 The Measurement of Operating The leverage leverage DOL measures extent to which operating costs are fixed S − VC DOL = S − VC − F Alternatively % ∆ EBIT DOL = % ∆ Sales 13 DOL influences relation between: • % ∆ Sales and % ∆ EBIT Sales and % % ∆ EBIT = DOL × % ∆ Sales DOL= 3 10% ∆ Sales 30% ∆ EBIT DOL= 0.5 10% ∆ Sales 5% ∆ EBIT High DOL advantageous Firms facing declining sales • when sales are expected to rise • try to reduce DOL by _____________________________ 14 Problem 1: Degree of Operating Leverage Zetacorp sold 40,000 units at $200 each in the past year. Fixed operating costs were $2m and variable cost $40 per unit. Interest charges amounted to $1m. The corporate tax rate is 40%. (a) What is Zetacorp’s DOL ? (b) What is the expected change in EBIT if sales rise 10% this year ? 15 S − VC (a ) DOL = S − VC − F = = = (b) % ∆ EBIT = DOL× ∆ % Sales = = 16 Looking at the same problem with an income statement approach Units Sales Rev. F VC EBIT 40 000 8 000 000 2 000 000 1 600 000 4 400 000 44 000 8 800 000 2 000 000 1 760 000 5 040 000 5 040 000 / 4 400 000 = 1.1455 17 Problem 2: Degree of Operating Leverage Llama Co sells 1 million units at $20 per unit. Variable costs are $6 per unit Fixed costs are $4 million Interest Expense is $2 million Tax rate is 33% (a) (b) Determine the DOL and EBIT ($$) Determine %∆ EBIT when sales fall by 20% and check by computing $$ EBIT 18 Solution to Problem 2: Llama Co’s DOL S − VC (a ) DOL = S − VC − F = = = 19 Llama Co continued (a)(ii) Sales Less VC Less F EBIT $20m $ 6m $ 4m $10m = = (b) Percentage ∆ EBIT New EBIT = 20 Llama Co continued 21 The Measurement of Financial The leverage leverage DFL measures extent to which interest­bearing debt is used by firm EBIT DFL = EBIT − I % ∆ NPAT DFL = % ∆ EBIT Alternatively 22 DFL influences relation between % ∆ EBIT and % ∆ NPAT % ∆ NPAT = DFL × % ∆ EBIT DFL=3 10% ∆ EBIT 30% ∆ NPAT DFL=0.5 10% ∆ EBIT 5% ∆ NPAT High DFL advantageous Firms facing declining EBIT • when EBIT is expected to rise • try to reduce DFL ___________________________ 23 Problem 3: Degree Of Financial Leverage (a) What is Zetacorp’s DFL ? (b) What is the expected change in NPAT if EBIT rises 10% this year ? 24 EBIT (a ) DFL = EBIT − I = = (b) %∆ NPAT = DFL × %∆ EBIT = = 25 Current + 10% EBIT EBIT Less I NPBT Less Tax NPAT 4 400 000 3 400 000 2 040 000 4 840 000 3 840 000 2 304 000 -1 000 000 -1 000 000 -1 360 000 -1 536 000 2 304 000 / 2 040 000 = 1.1294 26 The Measurement of Total leverage DTL jointly determined by DOL and DFL DTL = DOL * DFL %∆ NPAT %∆ EBIT %∆ NPAT = ∗ %∆ Sales %∆ Sales %∆ EBIT DTL influences relation between %∆ Sales and %∆ NPAT % ∆NPAT = % ∆Sales∗ DOL∗ DFL DTL=3 10%∆ Sales 30%∆ NPAT DTL=0.5 10%∆ Sales 5%∆ NPAT 27 High DTL advantageous when sales are expected to rise Firms facing declining sales try to reduce DTL by cutting: • fixed operating costs (overheads) • fixed financial charges (debt levels) 28 Problem 4: Degree of Total Leverage (a) What is Zetacorp’s DTL ? (b) What is the expected change in NPAT if sales rise 10% this year ? 29 Solution to Problem 4: (a ) DTL= DOL×DFL = = (b) %∆ NPAT = DTL×%∆Sales = = 30 Proof (part 1): Units Sales Rev. Less F Less VC EBIT 40 000 8 000 000 -2 000 000 -1 600 000 4 400 000 44 000 8 800 000 -2 000 000 -1 760 000 5 040 000 31 Proof continued: EBIT Less I NPBT Less Tax NPAT 4 400 000 -1 000 000 3 400 000 -1 360 000 2 040 000 5 040 000 -1 000 000 4 040 000 -1 616 000 2 424 000 2 424 000 / 2 040 000 = 1.1882 32 ...
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