Chapter 12

Chapter 12
Determining the
Financing Mix
Learning Objectives
1.
2.
3.
4.
5.
Distinguish between business and financial risk.

Use break-even analysis.
Understand the relationship between operating,
financial, and combined leverage.
Discuss the concept of an optimal capital
structure.
Use the basic tools of capital structure
management.
Copyright 2014 Pearson Education, Inc. All rights reserved.
12-2
Figure 12-1
12-3
UNDERSTANDING THE DIFFERENCE

BETWEEN BUSINESS AND
FINANCIAL RISK
12-4
Risk
Risk is variability associated with expected
revenue or income streams. Such variability
may arise due to:
Choice of business line (business risk)
Choice of an operating cost structure (operating
risk)
Choice of a capital structure (financial risk)
12-5
Business Risk
Business risk is the variation in the firms
expected earnings attributable to the
industry in which the firm operates. There
are four determinants of business risk:
The stability of the domestic economy
The exposure to, and stability of, foreign
economies
Sensitivity to the business cycle
Competitive pressures in the firms industry
12-6
Operating Risk
Operating risk is the variation in the firms
operating earnings that results from firms
cost structure (mix of fixed and variable
operating costs).
Earnings of firms with higher proportion of
fixed operating costs are more vulnerable to
change in revenues.
12-7
Financial Risk
Financial risk is the variation in earnings as
a result of firms financing mix or proportion
of financing that requires a fixed return.
12-8
BREAK-EVEN ANALYSIS
12-9
Break-Even Analysis
Break-even analysis is used to determine
the break-even quantity of a firms output
by examining the relationships among the
firms cost structure, volume of output, and
profit.
Break-even may be calculated in units or
sales dollars.
Break-even point indicates the point of sales
or units at which EBIT is equal to zero.
12-10
Break-Even Analysis
Use of break-even model enables the financial
manager to
determine the quantity of output that must
be sold to cover all operating
costs, as distinct from financial costs.
calculate the EBIT that will be
achieved at various output levels.
12-11
Essential Elements of
the Break-Even Model
Break-even analysis requires information on
the following:
Fixed Costs
Variable Costs
Total Revenue
Total Volume
12-12
Essential Elements of
the Break-Even Model
Break-even analysis requires classification of
costs into two categories:
Fixed costs or indirect costs
Variable costs or direct costs
Since all costs are variable in the long run,

break-even analysis is a short-run concept.
12-13
Fixed or Indirect Costs

These costs do not vary in total amount as
sales volume or the quantity of output
changes.
As production volume increases, fixed costs per
unit of product falls, as fixed costs are spread over
a larger and larger quantity of output (but total
remains the same).
Fixed costs vary per unit but remain fixed in total.
The total fixed costs are generally fixed for a
specific range of output.
12-14
Fixed Costs Examples

1.
2.
3.
4.
Administrative salaries
Depreciation
Insurance
Lump sums spent on intermittent advertising
programs
5. Property taxes
6. Rent
12-15
Variable or Direct Costs

Variable costs vary as output changes. Thus
if production is increased by 5%, total
variable costs will also increase
by 5%.
12-16
Variable Costs Examples

1. Direct labor
2. Direct materials
3. Energy costs (fuel, electricity, natural gas)
associated with the production
4. Freight costs
5. Packaging
6. Sales commissions
12-17
The Behavior of Costs
12-18
Semivariable Costs
12-19
Revenue
Total revenue is the total sales dollars.
Total revenue = P Q
P = selling price per unit
Q = quantity sold
12-20
Volume
The volume of output refers to the
firms level of operations and may be
indicated either as a unit quantity or as
sales dollars.
12-21
Break-Even Point (BEP)

BEP = Point at which EBIT equals zero
EBIT = (Sales price per unit) (units sold)
[(variable cost per unit) (units sold)
+ (total fixed cost)]
12-22
Break-Even Point (BEP)
12-23
SOURCES OF OPERATING
LEVERAGE
12-24
Operating Leverage
Operating leverage measures the sensitivity
of the firms EBIT to fluctuation in sales,
when a firm has fixed operating costs.
If the firm has no fixed operating costs,
EBIT will change in proportion to the change
in sales.
12-25
Operating Leverage
Example : If a company has an operating
leverage (OL) of 6, then what is the change in
EBIT if sales increase by 5%?
% change in EBIT = OL % change in sales
= 5% 6 = 30%
Thus, if the firm increases sales by 5%, EBIT
will increase by 30%
12-26
Operating Leverage
Operating leverage is present when
% change in EBIT / % change in sales is
> 1.00
The greater the firms degree of operating
leverage, the more the profits will vary in
response to change in sales.
12-27
Financial Leverage
Financial leverage means financing a portion
of the firms assets with securities bearing a
fixed (limited) rate of return in hopes of
increasing the return to the common
stockholders.
Thus the decision to use preferred stock or
debt exposes the common stockholders to
financial risk.
Variability of EBIT is magnified by the firms
use of financial leverage.
12-28
Capital Structure Plans

A firm employing financial leverage is
exposing its owners to financial risk when:
Percentage change in EPS divided by percentage
change in EBIT is greater than 1.00
12-29
CAPITAL STRUCTURE
THEORY
12-30
Financial & Capital Structure

Financial Structure
Mix of all items that appear on the right-hand
side of the companys balance sheet (see Table
12-7).
Capital Structure
Mix of the long-term sources of funds used by
the firm
Capital Structure = Financial Structure Noninterest- bearing liabilities (accounts payable,
accrued expenses)
12-31
Financial & Capital Structure
12-32
Designing a Capital Structure

Designing a prudent capital structure
requires answers to the following:
Debt maturity composition: How should a
firm best divide its total fund sources
between short-term and long-term debt
components?
Debt-equity composition: What mix of debt
and equity should the firm use?
12-33
Capital Structure Management

A firm should mix the permanent sources of
funds in a manner that will maximize the
companys stock price, or minimize the cost
of capital.
A proper mix of fund sources is called the
optimal capital structure.
12-34
Capital Structure Theory

Theory focuses on the effect of financial
leverage on the overall cost of capital to the
enterprise.
In other words, Can the firm affect its
overall cost of funds, either favorably
or unfavorably, by varying the mixture
of financing used?
Firms strive to minimize the cost of using
financial capital so as to maximize
shareholders wealth.
12-35
Independence Position
According to Modigliani & Miller, the total
value of the firm is not influenced by the
firms capital structure. In other words, the
financing decision is irrelevant!
Their conclusions were based on restrictive
assumptions (such as no taxes, capital
structure consisting of only stocks and
bonds, perfect or efficient markets).
12-36

Figure 12-5 shows that the firms value
remains the same, despite the differences in
financing mix.
Figure 12-6 shows that the firms cost of
capital remains constant, although cost of
equity rises with increased leverage.
12-37
Firm Value and

Capital Structure
12-38

The implication of these figures for financial
managers is that one capital structure is just
as good as any other.
However, the above conclusion is possible
only under strict assumptions.
We next turn to a market and legal
environment that relaxes these restrictive
assumptions.
12-39
Extensions to Independence
Hypothesis: The Moderate Position
The moderate position considers how the
capital structure decision is affected when
we consider:
Interest expense is tax deductible (a benefit of
debt)
Debt financing increases the risk of default (a
disadvantage of debt)
Combining the above (benefit & drawback)

provides a conceptual basis for designing a
prudent capital structure.
12-40
Impact of Taxes on
Capital Structure
Interest expense is tax deductible.
Because interest is deductible, the use of
debt financing should result in higher total
market value for firms outstanding
securities.
Tax shield benefit = rd(m)(t)
r = rate, m = principal, t = marginal tax
rate
12-41
Impact of Taxes on
Capital Structure
Since interest on debt is tax deductible, the
higher the interest expense, the lower the
taxes.
Thus, one could suggest that firms should
maximize debt indeed, firms should go for
100% debt to maximize tax shield benefits!!
But we generally do not see 100% debt in
the real world why not?
12-42
Impact of Taxes on
Capital Structure
One possible explanation is:
Bankruptcy costs
12-43
Impact of Bankruptcy on Capital

Structure
The probability that a firm will be unable to
meet its debt obligations increases with
debt. Thus probability of bankruptcy (and
hence costs) increase with increased
leverage. Threat of financial distress causes
the cost of debt to rise.
As financial conditions weaken, expected
costs of default can be large enough to
outweigh the tax shield benefit of debt
financing.
12-44
Impact of Bankruptcy on Capital

Structure
So, higher debt does not always lead to a
higher value after a point, debt reduces
the value of the firm to shareholders.
This explains a firms tendency to restrain
itself from maximizing the use of debt.
Debt capacity indicates the maximum
proportion of debt the firm can include in its
capital structure and still maintain its lowest
composite cost of capital (see Figure 12-7).
12-45
Firm Value and Agency Costs

To ensure that agent-managers act in
shareholders best interest, firms must:
1. Have proper incentives
2. Monitor decisions
bonding the managers

auditing financial statements
structuring the organization in unique
ways that limit useful managerial decisions
reviewing the costs and benefits of management perquisites
The costs of the incentives and monitoring must be borne

by the stockholders.
12-46
Impact of Agency Costs on Capital

Structure
Capital structure management also gives rise to
agency costs. Bondholders are principals, as
essentially they have given a loan to the
corporation, which is owned by shareholders.
Agency problems stem from conflicts of interest
between stockholders and bondholders. For
example, pursuing risky projects may benefit
stockholders, but may not be appreciated by
bondholders.
Bondholders greatest fear is default by corporation
or misuse of funds leading to financial distress.
12-47

Structure
Agency costs may be minimized by agreeing to
include several protective covenants in the bond
contract.
Bond covenants impose costs (such as periodic
disclosure) and impose constraints (on type of
project that management can undertake, collateral,
distribution of dividends, limits on further
borrowing).
Agency costs depend on the level of debt. At lower
levels of debt, creditors may not insist on a long list
of bond covenants to monitor. Thus, agency cost
and cost of financing are reduced at lower levels of
debt.
12-48

Structure
Figure 12-8 indicates the trade-offs.
For example, increasing the protective
covenants will reduce the interest cost but
increase the monitoring cost (which is
eventually borne by the shareholders).
12-49
The Agency Costs of Debt
12-50
Managerial Implications
Determining the firms financing mix is
critically important for the manager.
We observe that the decision to maximize the
market value of leveraged firm is influenced
primarily by the present value of tax shield
benefits, present value of bankruptcy costs,
and present value of agency costs.
12-51
THE BASIC TOOLS OF

CAPITAL STRUCTURE
MANAGEMENT
12-52
The Basic Tools of Capital

Structure Management
Two basic tools used to evaluate capital
structure decisions are:
EBIT-EPS analysis
Financial leverage ratios
12-53
Comparative Leverage Ratios

Two types of ratios (as covered in Chapter
4), balance sheet leverage ratios and
coverage ratios, can be computed and
compared to industry norms.
If the ratios are significantly different from
industry average, the managers must
analyze further.
12-54
Capital Structure Determinants

(Survey Results)
A survey of 392 corporate executives revealed the
following ten factors as important determinants of
capital structure decision:
Financial flexibility:
Firms bargaining position is stronger if it has choices.
Credit rating:
Downgrading of credit rating will increase borrowing costs
and thus managers try to avoid anything that will trigger
credit downgrades.
12-55

(Survey Results) (cont.)
Insufficient internal funds:
Firms follow a pecking order for raising funds internal funds
followed by debt and then equity.
Level of interest rates:

Firms tend to borrow when interest rates are low relative to
their expectations.
Interest tax savings:

Debt is cheaper due to the tax benefit on interest paid.
Dividend distribution does not receive any tax benefit.
12-56

Transaction costs and fees:
Cost of issuing equity is relatively higher than debt, making
equity a less attractive source.
Equity valuation:
If shares are undervalued, firms will like to issue debt, and
vice versa. Thus, valuation impacts the timing of security
issue.
Comparable firm debt levels:

Firms from similar businesses tend to have similar capital
structures.
12-57

Bankruptcy/distress costs:
Higher level of existing debt will increase the
likelihood of financial distress.
Customer/supplier discomfort:
High levels of debt will increase discomfort among
customer (fearing disruption in supply) and
suppliers (fearing disruption in demand and
late/non- payment on existing contracts).
12-58
Key Terms
Balance sheet leverage ratios

Break-even quantity
Business risk
Capital structure
Combined or total leverage
Coverage ratios
Debt capacity
Debt-equity composition
Debt maturity composition
Direct costs
EBIT-EPS indifference point
Financial leverage
Financial risk
12-59
Key Terms
Financial structure
Fixed costs
Indirect costs
Operating risk
Operating leverage
Optimal capital structure
Optimal range of financial leverage
Tax shield
Total revenue
Variable costs
Volume of output
12-60

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Chapter 12

Distinguish between business and financial risk.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

UNDERSTANDING THE DIFFERENCE

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Since all costs are variable in the long run,

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Fixed or Indirect Costs

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Fixed Costs Examples

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Variable or Direct Costs

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Variable Costs Examples

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The Behavior of Costs

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Break-Even Point (BEP)

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Break-Even Point (BEP)

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Capital Structure Plans

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Financial & Capital Structure

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Financial & Capital Structure

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Designing a Capital Structure

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Capital Structure Management

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Capital Structure Theory

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Capital Structure Theory

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Firm Value and

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Capital Structure Theory

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Combining the above (benefit & drawback)

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

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Impact of Bankruptcy on Capital