Chapter16-17CapitalStructureDecisions

# Chapter16-17CapitalStructureDecisions - OEM 2009 Program...

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OEM 2009 Program Capital Structure Decisions Page 1 CHAPTERS 16 AND 17 Capital Structure Decisions Breakeven Analysis Assumptions : ± Firms A and B each have sales of 100 units with a price of \$5 per unit. ± Firm B has traded fixed costs for variable costs. ± Firm B has levered itself by issuing debt. Breakeven Analysis Firm A Firm B Sales \$500 \$500 Variable Costs -\$350 -\$200 Fixed Costs \$0 -\$150 Units 100 EBIT \$150 \$150 Interest \$0 -\$60 EBT \$150 \$90 Taxes (40%) -\$60 -\$36 Net Income \$90 \$54 Breakeven Analysis ± EBIT Breakeven : Q* = [F] / [P - V] S *= [F] / [1 - (V/P)] [F] / [1 (V/P)] ± Net Income Breakeven : Q* = [F + I] / [P - V] S* = [F + I] / [1 - (V/P)] Breakeven Analysis ± Firm B EBIT Breakeven : Q* = [\$150] / [\$5 - \$2] Q*= 50 Units S* = [\$150] / [1 - (\$2/\$5)] S* = [\$150] /[.60] = \$250 S* = [50 units] [\$5] = \$250 Breakeven Analysis Units 50 Firm A Firm B Sales \$250 \$250 Variable Costs -\$175 -\$100 Fixed Costs \$0 -\$150 EBIT \$75 \$0 Interest \$0 -\$60 EBT \$75 -\$60 Taxes (40%) -\$30 \$24 Net Income \$45 -\$36

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OEM 2009 Program Capital Structure Decisions Page 2 Breakeven Analysis ± Firm B Net Income Breakeven : Q* = [\$150 + \$60] / [\$5 - \$2] Q*= 70 Units S* = [\$150 + \$60] / [1 - (\$2/\$5)] S* = [\$210] /[.60] = \$350 S* = [70 units] [\$5] = \$350 Breakeven Analysis Units 70 Firm A Firm B Sales \$350 \$350 Variable Costs -\$245 -\$140 Fixed Costs \$0 -\$150 EBIT \$105 \$60 Interest \$0 -\$60 EBT \$105 \$0 Taxes (40%) -\$42 \$0 Net Income \$63 \$0 Capital Structure and Risk ± Factors to consider z Business risk z Financial risk (leverage) z Need for financial flexibility z Tax position z Managerial perspective ¾ Conservative ¾ Aggressive Capital Structure and Risk K S = K RF + [K M -K RF ][ β L ] β = β + β (1 T)(D/E L U + U (1-T)(D/E) K S =K RF + [K M RF ][ β U ] + [K M RF ][ β U ](1-T)(D/E) Capital Structure and Risk K S RF + Business risk premium + Financial risk premium ± Business risk concerns the uncertainty inherent in EBIT. Business Risk Probability Lower Risk 0 EBIT Higher Risk
OEM 2009 Program Capital Structure Decisions Page 3 Business Risk ± Business risk factors z Demand variability z Sales price variability z Input price variability z Ability to adjust output prices for changes in input prices z Operating leverage Operating Leverage Profit Fixed costs = \$0; Variable Costs = \$3.50/Unit : 0 100 200 300 400 0 10 20 30 40 5 60 70 80 90 100 110 120 13 140 1 50 Units Sold Revenues Costs Breakeven = 0 Units Operating Leverage Fixed costs = \$150; Variable Costs = \$2.00/Unit : Profit 0 100 200 300 400 130 150 Units Sold Revenues Costs Fixed Costs Breakeven = 50 Units Operating Leverage Fixed costs = \$250; Variable Costs = \$1.00/Unit : Profit 0 100 200 300 400 3 12 14 Units Sold Revenues Costs Fixed Costs Breakeven = 62.5 Units Operating Leverage Low Operating Leverage Can Use Operating Leverage to Increase Expected EBIT, But Risk Also Increases EBIT L EBIT H High Operating Leverage Sales Fixed Costs DOL Leverage Functions EBIT / BEP NI / ROE / EPS Interest DTL DFL

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OEM 2009 Program Capital Structure Decisions Page 4 Operating Leverage DOL = Degree of operating leverage [% Δ Sales] [DOL] = % Δ EBIT BEP = EBIT/TA Assuming no change in TA: [% Δ Sales] [DOL] = % Δ BEP Operating Leverage Firm A Firm B Sales \$500 \$500 Variable Costs -\$350 -\$200 Fixed Costs \$0 -\$150 Sales 500 EBIT \$150 \$150 EBIT: Sales 20% \$180 \$210 EBIT: Sales 20% \$120 \$90 % Δ EBIT 20% 40% 500 600 400 ± ± + - Operating Leverage [% Δ Sales] [DOL] = % Δ EBIT DOL = [% Δ EBIT] / [% Δ Sales] DOL A = [20%] / [20%] = 1.0 DOL B = [40%] / [20%] = 2.0 Operating Leverage DOL = (P-V)(Q) (P-V)(Q) - F DOL B = DOL B = \$300 / \$150 = 2.0 (5-2)(100) (5-2)(100) - 150 Financial Leverage
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## This note was uploaded on 05/12/2010 for the course FIN 5405 taught by Professor Tapley during the Summer '08 term at University of Florida.

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Chapter16-17CapitalStructureDecisions - OEM 2009 Program...

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