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1439078084_226147

# 1439078084_226147 - A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15...

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4/11/2010 Chapter 15. Tool Kit for Capital Structure Decisions BUSINESS RISK AND FINANCIAL RISK (Section 15.2) Input Data Plan A Plan U Plan L Required capital \$200 \$200 \$200 Book equity \$200 \$200 \$150 Debt \$50 Interest rate 8% 8% 8% Sales price (P) \$2.00 \$2.00 \$2.00 Tax rate (T) 40% 40% 40% Expected units sold (Q) 110 110 110 Fixed costs (F) \$20 \$60 \$60 Variable costs (V) \$1.50 \$1.00 \$1.00 Income Statements Plan A Plan U Plan L \$220.0 \$220.0 \$220.0 Fixed costs \$20.0 \$60.0 \$60.0 \$165.0 \$110.0 \$110.0 EBIT \$35.0 \$50.0 \$50.0 Interest \$0.0 \$0.0 \$4.0 EBT \$35.0 \$50.0 \$46.0 Tax \$14.0 \$20.0 \$18.4 Net income \$21.0 \$30.0 \$27.6 Key Performance Measures Plan A Plan U Plan L \$21.0 \$30.0 \$30.0 ROIC = NOPAT/Capital 10.5% 15.0% 15.0% ROE = NI/Equity 10.5% 15.0% 18.4% We can use the following formula to find the exact breakeven point. FC Plan A F ÷ ( P V ) \$20 ÷ \$2.00 \$1.50 40 Units. Plan L In Chapter 6, we introduced the idea that risk has two principal components, market risk and stand-alone risk. Market risk is measured by beta, while stand-alone risk consists of both market risk plus an element of risk that can be eliminated through diversification. In this chapter, we introduce two new dimensions of risk, business risk and financial risk. Business risk is the risk inherent in the firm's operations, and it would be there even if used no debt. Financial risk is the additional risk borne by the stockholders as a result of the use of debt. Operating Leverage reflects the amount of fixed costs embedded in a firm's operations. Thus, if a high percentage of a firm's costs are fixed, hence continue even if sales decline, then the firm is said to have high operating leverage. High operating leverage produces a situation where a small change in sales can result in a large change in operating profit. The following example compares two operational plans with different degrees of operating leverage. Figure 15-1. Illustration of Operating and Financial Leverage (Millions of Dollars and Millions of Units, Except Per Unit Data) Sales revenue (P × Q) Variable costs (V × Q) NOPAT = EBIT(1 T) Q BE = (P V) Q BE = Q BE = Q BE = A B C D E F G H I 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59

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F ÷ ( P V ) \$60 ÷ \$2.00 \$1.00 60 Units. Figure 15-2. Operating Leverage and Financial Leverage Q BE = Q BE = Q BE = 0 20 40 60 80 100 120 140 -\$60 -\$40 -\$20 \$0 \$20 \$40 \$60 Panel a: Operating Leverage Units Sold (Millions) NOPAT (Millions) -6% 0% 6% 12% 18% -6% 0% 6% 12% 18% Panel b: Financial Leverage Return on Invested Capital Return on Equity Plan A Break-even Q A B C D E F G H I 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94
FINANCIAL RISK AND LEVERAGE Leverage magnifies the ROIC. See Panel b of Figure 15-2 above. STRASBURG'S VALUATION Figure 15-3. Strasburg’s Valuation Analysis (Millions of Dollars Except Per Share Data) Input Data (Millions Except Per Share Data) Tax rate 40.00% Debt (D) \$50.00 10.00 \$20.00 NOPAT \$30.00 Free Cash Flow (FCF) \$30.00 Growth rate in FCF 0.00% Capital Structure (Millions Except Per Share Data) \$200.00 Total value (V = D + S) \$250.00 20% 80% Cost of Capital 8.00% Beta (b) 1.25 6.30% 6.00% 13.80% WACC 12.00% Intrinsic Valuation (Millions Except Per Share Data) \$250.00 \$0.00 Total intrinsic value of firm \$250.00 \$50.00 Intrinsic value of equity \$200.00 10.00 Intrinsic price per share \$20.00

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