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Chapter 14 Powerpoint

# 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
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
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
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
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
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.
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
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
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
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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