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Chapter 14 Powerpoint - CHAPTER 14 Capital Structure and...

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Capital Structure and Leverage CHAPTER 14
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C a p i t a l S t r u c t u r e F I N 3 4 0 3 - B u s i n e s s F i n a n c e A p p l i c a t i o n s B a s i c s C a p i t a l S t r u c t u r e T h e o r i e s B r e a k e v e n L e v e r a g e F u n c t i o n s B u s i n e s s a n d F i n a n c i a l R i s k B a s i c E q u a t i o n s M o d i g l i a n i & M i l l e r U s i n g V a l u a t i o n E q u a t i o n s O p t i m a l C a p i t a l S t r u c t u r e C u r r e n t V i e w S t o c k h o l d e r s v s . B o n d h o l d e r s
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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.
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Breakeven Analysis Firm A Firm B Sales $500 $500 Variable Costs -$350 -$200 Fixed Costs $0 -$150 EBIT $150 $150 Interest $0 -$60 EBT $150 $90 Taxes (40%) -$60 -$36 Net Income $90 $54 Units 100
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Breakeven Analysis EBIT Breakeven : Q* = [F] / [P - V] S* = [F] / [1 - (V/P)] Net Income Breakeven : Q* = [F + I] / [P - V] S* = [F + I] / [1 - (V/P)]
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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
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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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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
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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
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Capital Structure and Risk Factors to consider Business risk Financial risk (leverage) Need for financial flexibility Tax position Managerial perspective Conservative Aggressive
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Capital Structure and Risk r S = r RF + [r M - r RF ][ β L ] β L = β U + β U (1-T)(D/E) r S = r RF + [r M - r RF ][ β U ] + [r M - r RF ][ β U ](1-T)(D/E)
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Capital Structure and Risk r S = r RF + Business risk premium + Financial risk premium Business risk concerns the uncertainty inherent in EBIT.
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Business Risk 0 EBIT Probability Lower Risk Higher Risk
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Business Risk Business risk factors Demand variability Sales price variability Input price variability Ability to adjust output prices for changes in input prices Operating leverage
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Operating Leverage 0 100 200 300 400 500 600 700 800 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Units Sold Revenues Costs $225 Profit Fixed costs = $0; Variable Costs = $3.50/Unit : Breakeven = 0 Units
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Operating Leverage 0 100 200 300 400 500 600 700 800 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Units Sold Revenues Costs Fixed Costs Fixed costs = $150; Variable Costs = $2.00/Unit : Breakeven = 50 Units $300 Profit
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Operating Leverage Fixed costs = $250; Variable Costs = $1.00/Unit : 0 100 200 300 400 500 600 700 800 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Units Sold Revenues Costs Fixed Costs Breakeven = 62.5 Units $350 Profit
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Operating Leverage EBIT L EBIT H Low Operating Leverage High Operating Leverage Can Use Operating Leverage to Increase Expected EBIT, But Risk Also Increases
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Sales EBIT / BEP NI / ROE / EPS Fixed Costs Interest DTL DOL DFL Leverage Functions
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Operating Leverage DOL = Degree of operating leverage [% Sales] [DOL] = % EBIT BEP = EBIT/TA Assuming no change in TA: [% Sales] [DOL] = % BEP
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