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The biggest challenge that a corporate financial

manager faces is to have an optimal capital structure

that results in an optimal capital balance between risk

and return and at the same time maximizes the firm’s

earning per share.

Learning objectives

After learning this chapter, you should be able to:

1. Know the term leverage.

2. Examine each type of leverage: operating and financial.

3. Understand and compute Degree of Leverage.

4. Understand and compute Indifference point.

Leverage

GOAL

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10.0 INTRODUCTION

What is leverage? Leverage exists from the firms’s investment and financing decisions that

directly affect the asset structure and the financial structure of the firm. For example looking

at the financial structure, when a particular company carries debt in its capital structure, the

company is leveraged. The more debt a company has the more is its leverage. What does

leverage do to a company then? In essence, leverage that exists in the asset structure and

financial structure accelerates the profitability of a company. It existence enable a company

to achieve greater rate of profit as compared to without leverage.

However, the use of leverage is goes hand in hand with risk that is the higher the leverage,

the higher the risk. This is because the use of leverage in the firm’s operations and financing

involves risk-return tradeoff. Our focus in this chapter is therefore, concerning the firm's

capital structure and the impact of leverage, and thus the risk-return tradeoff.

10.1 OPERATING LEVERAGE a) Fixed Operating Costs

It represents the costs incurred by the firm in a given period regardless of the sales

volume. It has no direct relationship with sales; that is the total amount will remains

constant and thus, per unit basis will declines with an increase in sales. These costs

include depreciation, rentals, lease charges, interest expenses, salaries and general

and administrative expenses.

b) Variable Operating Costs

It represents the costs that vary in direct proportion to the firm's productions and

sales; that are total variable costs will increase in direct proportions with sales, but

per unit basis will remains constant. These costs include labor, materials, selling

expenses, sales commissions, and direct overhead.

For certain type of costs such as salaries and office expenses, clear classifications

cannot be made. These semi-variable costs remain fixed over a given range of sales,

and tend to increase drastically in a step up fashion as sales reach certain maximum

point. For the purpose of the analysis, these costs will be included in variable costs'

component if it represents a small percentage of the firm's total operating costs.

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Under normal conditions, the existence of high fixed costs relate to high capital

investment made by the firm such as in a highly automated manufacturing facilities.

This mode of operations refers to capital-intensive operations that result in high fixed

costs and low variable costs.

10.1.1 Break Even Analysis

Break even analysis focus on the relationship between sales volume and

profitability, that relates directly to the firm's total cost structure; fixed

operating costs and variable or direct costs. The understanding of break-even

analysis is utmost important in profit planning.

Determining Break Even Point

The break-even analysis or cost-volume-profit analysis involves

finding the level of sales where operating profit or earnings before interest and tax (EBIT) equals zero; that is total revenues equal total

costs. In essence, it is the point where the all costs are covered and

any sales above that level will contribute directly (price minus variable

cost) to the operating profit. EBIT is given by:

EBIT = TR – TC

= QP – QV – FC

= Q (P – V) – FC

Where FC : Fixed operating costs including depreciation

V : Variable cost per unit

Q : Sales volume in units

P : Price per unit

QV : Total variable costs, also presented as VC

TR : Total operating revenues (QP) or sales (S)

TC : Total operating costs; FC + QV

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At break-even point, EBIT is zero; therefore the above equation can

be used to solve for Q or break-even point in units (BEunits):

EBIT = Q (P – V) – FC

Q = BEunits = FC / (P – V)

To illustrate, consider Marisa Manufacturing that sells its only product

at RM1.00 per unit, has a variable cost of RM0.60 per unit, and fixed

costs of RM20,000. Therefore, the company must sell 50,000 units to

break even:

BEunits = 20,000 / (1.00 – 0.60)

= 50,000 units

A graphic illustration of the break-even concept is presented in Figure

10-1. It shows that Marisa has to sell at least 50,000 units or

RM50,000 (=50,000 x 1) to break even. If sales are greater than

50,000 units, it will show a positive EBIT; or else, EBIT will be

negative.

Any changes in the price (P), unit variable cost (V), and/or fixed cost (FC) will alter the break-even point, hence the firm's profitability.

For example, if Marisa decides to change its mode of operations that

leads to the change in costs structure as follows: (1) fixed cost

RM8,000; (2) variable cost RM0.80; and (3) the selling price will

remain at RM1.00. This will shift the fixed cost line down, and the

break-even point declines to 40,000 units (=8,000 / (1.00 – 0.80)).

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Figure 10.1 Graphic Illustration Of Break Even

Sales Break Even

For a firm with more than one product line, break even can be

calculated in terms of Ringgits instead of units. It involves the same

formula except that sale break-even uses contribution margin (CM) in place of ringgit contribution to fixed cost and profit. Sales break

even (BEs) can be calculated as follows:

Using the same example for Marisa, break even sales equals to

RM50,000:

BEsales = 20,000 / (1 – (0.60 / 1.00))

= RM50,000

-30-20-10

0102030405060708090

0 10 20 30 40 50 60 70 80

Units in thousands

RM

in th

ousa

nds TR

TC

VC

FC

EBIT

CM = 1 – Variable cost ratio

= 1 – (V / P)

Alternatively CM = 1 – (QV / S)

BEsales = FC / [1 – (V / P)]

= FC / CM

Where V, QV : Variable cost per unit, Total variable costs

P, S : Price per unit, Total sales in Ringgits

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Break-even analysis can also be used in profit planning. For example,

Marisa Manufacturing would like to have at least RM20,000 of EBIT in

the coming period. Given that the cost structure remains constant, it

has to sell 100,000 units or RM100,000 in order to achieve that profit

target:

BEunits = (FC + Profit) / (P – V)

= (20,000 + 20,000) / (1.00 – 0.60)

= 100,000 units

BESales = (FC + Profit) / 1 – (V / P)

= (20,000 + 20,000) / 1 – (0.60 / 1.00)

= RM100,000

The break-even analysis is an important analysis in profit and

production capacity planning. It aids the financial manager to set the

appropriate capital structure and price structure that results in higher

firm's value in long-term.

Cash Break Even

The cash break-even (CBE) concerns with the sales level that the

firm must achieve to meet its operating cash requirements. This

analysis is important since cash receipts and expenditures do not

correspond directly with the sales and expenses as shown in the

income statements. It focuses on the non-cash expense (N), such as

depreciation, which is normally treated as part of the fixed cost's

component.

In the cash break even, the non-cash expenses are not included as

they will overstate the cash break even. Assuming that Marisa

Manufacturing in the previous example, has RM4000 of depreciation

charges are part of its fixed costs of RM20,000, then its cash break

even in units and sales can be computed as follows:

CBEunits = (FC – N) / (P – V)

= (20,000 – 4000) / (1.00 – 0.60)

= 40,000 units

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CBEsales = (FC – N) / [ 1 – (V / P)]

= (20,000 – 4,000) / [1 – (0.60 / 1.00)]

= RM40,000

Other things being equal, Marisa has to achieve at least RM40,000 in

sales to meet its cash operating needs. If sales level is below than

RM40,000, Marisa may face liquidity problems that will affect its

overall operation significantly.

Break Even Margin

The break-even margin is used to assess the margin of safety for a

given level of sales. It relates the firms' current sales levels to the

break even point, and it is a measure of risk; that is how much sales

can decline before it hits break even point that result in negative

operating earnings. For example, if Marisa's current sales (S0) are at

RM80,000, break-even margin (BEM) can be computed as follows:

BEM = (S0 – BEsales) / S0

= (80,000 – 50,000) / 80,000

= 37.5%

The above calculation shows that Marisa's sales could decline by

37.5% before it faces any financial problems. The margin is relatively

high, and therefore is preferred, because higher margin associates

with lower business risk.

Although break-even analysis is an important part in planning, it has

some limitations in its usage. It is applicable only over a relevant

range of operations as fixed and/or variable costs may change with a

higher level of operations. The classification of fixed versus variable

cost is sometimes difficult especially when the majority of the cost

components are semi-variable in nature. Other aspects of cautions are

that break-even analysis assumes that variable cost and the marginal

revenues remain constant over time, which may not be the case in

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real conditions. Therefore, the use of break-even analysis in planning

and financial decision-making must be done judiciously.

10.1.2 The Degree of Operating Leverage

The operating leverage is concern with the amount of fixed cost employed by

a firm in its cost structure. A high degree of operating leverage indicates that:

1. A high percentage of a firm's total costs is fixed; and

2. A relatively small change in sales will lead to a large change in

earnings before interest and taxes (EBIT) or operating income.

A high fixed costs in the firm's cost structure are a result of high capital

investment in its operations; capital intensive. The mode of operations is

highly automated with less labor in used that result in lower variable costs and

higher fixed costs. To further illustrate the effects the firm's investment in

capital asset on its potential return, consider the examples shown in Table

10.1.

Table 10.1 Marisa Inc., Mode of Operations and Relative DOL

Capital intensity Low Average High Price (P) RM1.00 RM1.00 RM1.00 Variable cost(V) RM0.80 RM0.60 RM0.40 Fixed cost (FC) RM8,000 RM20,000 RM36,000 Break even Sales RM40,000 RM50,000 RM60,000 Break even Units 40,000 units 50,000 units 60,000 units

In thousands of RM Sales (S=PQ) Less: Fixed cost (FC) Variable cost (VC=VQ)

RM70.00 8.00

56.00

RM84.008.00

67.20

RM70.00 20.00 42.00

RM84.0020.0050.40

RM70.00 36.00 28.00

RM84.0036.0033.50

Operating profit (EBIT) RM 6.00 RM 8.80 RM 8.00 RM13.60 RM 6.00 RM14.40

Changes in EBIT 46.67% 70.00% 140.00% Changes in sales 20.00% 20.00% 20.00% DOL=(∆EBIT / EBIT0) / (∆S / S0)

2.33x 3.50x 7.00x

It shows the effects of change in sales on the company's operating profits

under different capital intensity level for Marisa Manufacturing. Mode of

operations with higher capital intensity experiences higher changes in profit at

140 percent given a similar change in sales level of 20 percent, compared to

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other alternatives with lower leverage of low and average capital intensity.

This proves that, the higher the leverage, the greater the impact of changes in

sales on operating profits.

At sales level of RM70,000, Marisa should employ the average capital

intensity as it represents average risk and higher average profits can be

expected. Different levels of sales may require different alternative of capital

intensity. For example, at sales level of RM45,000; alternative with low capital

intensity is preferred as the other two alternatives will result in negative

operating profit.

Determination of Degree of Operating Leverage

As previously mentioned, the degree of operating leverage is closely

related to the mode of operations employed by the firm. High degree

of operating leverage simultaneously reflects higher business risk due

to the possibility that the firm is unable to cover the fixed costs.

The degree of operating leverage (DOL), is define as the fractional

change in EBIT due to a fractional change in sales.

To illustrate, let assume that Marisa has decided to adopt average

capital intensity with current sales of RM70,000(t0) for its operations.

Refer to Table 8.1, third column for relevant financial data.

DOL = Fractional change in EBIT / Fractional change in sales

= (∆EBIT / EBIT0) / (∆S / S0)

Where ∆ : Change

∆EBIT : EBIT1 – EBIT0

∆S : Sales1 – Sales0

DOL = ((13.60 – 8.00) / 8.00) / ((84.00 – 70.00) / 70.00)

= 3.5x

In order to simplify the calculations, the degree of operating leverage

can also be calculated as follows:

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DOLQ = Degree of operating leverage at point Q; at sales quantity or

units

= [Q (P – V)] / [Q (P – V) – FC]

= (70,000(1.0 – 0.60)) / (70,000 (1.0 – 0.6) – 20,000)

= 3.5x

Alternatively, it can be calculated based on level of sales in Ringgit

rather than units,

DOLS = (S – QV) / (S – QV – FC)

= (70,000 – 42,000) / (70,000 – 42,000 – 20,000)

= 3.5x

This shows that when sales are at the RM70,000, every 1% change in

sales, increases, or decrease, will result in corresponding 3.5%

increase or decrease in operating profit respectively. Therefore, when

sales increase to RM84,000, which is an increase of 20%, operating

profit should increase by 70% (=3.5 x 20%) to RM13,600 (=8,000 x

1.70). Table 10.1 shows that higher capital intensity will result on

higher DOL. Thus, any change in sales will have a greater impact on

EBIT.

To have a better understanding of the principles of DOL, consider the

illustrations for Marisa Manufacturing presented in Table 10.2.

Relevant financial data refers to average capital intensity with fixed

costs of RM20,000, variable cost of RM0.60 per unit, and selling price

of RM1.00 per unit.

Table 10.2 Marisa Manufacturing: Degree of Operating Leverage at Different Sales

Level (thousands of RM)

Sales level Above BE Below BE At BE Expected sales Less: Current sales

RM84.0070.00

RM63.0070.00

RM46.0040.00

RM32.00 40.00

RM60.0050.00

Changes in sales RM14 –RM7.00 RM6.00 –RM8.00 RM10.00Percentage change 20% –10% 15% –20% 20% Expected EBIT Less: Current EBIT

RM13.608.00

RM5.208.00

–RM1.60–4.00

–RM7.20 –4.00

RM4.000.00

Changes in EBIT RM5.60 –RM2.80 RM2.40 –RM3.20 RM4.00Percentage change 70% –35% –60% 80% ∞DOL 3.5x 3.5x –4.0x –4.0x ∞

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The illustrations showed in Table 10.1 and 10.2 set forth a number of

important concepts in interpreting and understanding DOL:

1. DOL is associated with current sales level.

2. DOL will remain constant regardless of whether the change in

sales is positive or negative.

3. The value of DOL does not depend on the magnitude of

change.

4. DOL is positive if the current sales level is above break-even

point, and vice versa.

5. The DOL is associated with the firm's capital intensity, that is

higher DOL represents higher capital intensity, and vice versa.

6. DOL is undefined at the break-even point as any change in

sales will constitute an infinite fractional change.

In the event that DOL is negative, it associates with current sales level

below the break-even point, and thus losses. From Table 8.2, any 1%

increase in sales will result in 4% reduction in losses and likewise any

1% decrease in sales will result in 4% increase in losses.

The understandings of DOL provide insight of the relative impact of

operating leverage on EBIT or the degree of business risk. It is

important in capital investment decisions as it has a direct impact on

the firm's value without exposing the firm to unnecessary risk.

10.2 FINANCIAL LEVERAGE

The operating leverage concerns with firm's cost structure that concerns with the relationship

between sales and operating profit or EBIT. On the other hand, financial leverage concerns

with the effects of financing decision on the owners' return, that is the relationship between

firm's operating profit and earnings available to common stockholders (EPS). Figure 10-2

shows the relationship between operating leverage and financial leverage; how each

leverage has an impact on the firm's profitability: earnings before interest and tax (EBIT),

and (2) earnings available to common stockholders respectively (EACS). The combination of

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these leverages is the total leverage that shows the relationship of changes in sales and its

impact on earnings per share.

Figure 10-2 Relationship of DOL, DFL, and DTL

Net sales

Less: Cost of goods sold Operating

Gross profit leverage

Less: Operating expenses (DOL)

Operating profit (EBIT) Total leverage

Less: Interest and taxes (DTL)

Net profit Financial

Less: Preferred dividends leverage

0Earnings available to common shareholders (DFL)

Figure 10-1 shows that financial leverage relates to the financing cost of the firm, particularly

the cost of debt or interest. The extent to which the firm uses debt financing or financial

leverage has direct implications on risk and returns tradeoff. For example, if the firm utilizes

high volume of debt in its financial structure:

1. The stockholders have less control of the firm;

2. It represents higher risk to the creditors or lenders and the firm alike; and

3. Return on owners' capital is magnified or leveraged.

Our concern here is with the impact on earnings after tax (EAT), and thus earnings per share (EPS) if there is a change in earnings before interest and taxes (EBIT) due to

change in sales level.

10.2.1 Degree of Financial Leverage

The degree of financial leverage (DFL) is defined as the percentage of

change in EPS that results from a given percentage change in EBIT. To

illustrate, refer to Table 10-3 for relevant financial data for Marisa Inc., with

current production level of 70,000 units. Please note that this exercise is the

continuation of sample illustrations on DOL in the previous section.

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Note that the change in EPS is similar to change in EAT. This assumption

holds true if there no preferred dividends in the capital structure of the firm.

The basis for understanding DFL is similar to that of DOL previously

introduced. The DFL can be calculated by applying the following formula:

DFL = Percentage ∆ in EPS / Percentage ∆ in EBIT

= 112% / 70%

= 1.60

Therefore, a 1% change in EBIT would result in 1.60% change in earning per

share, and vice versa.

Table 10-3 Marisa Inc.; Operating Characteristics with Change in Sales

Capital intensity

Average

Price (P) RM1.00

Unit variable cost (V) RM0.60

Fixed cost (F) RM20,000

Break even Sales RM50,000

Break even Units 50,000 units

Current sales level 70,000 units

Ringgits in thousands

Current Sales

Expected Sales

Change

Sales Less: Fixed cost (F) Variable cost (VQ)

RM70.00 20.00 42.00

RM84.00 20.00 50.40

RM14.00

Operating profit (EBIT) Less: Interest (I)

RM 8.00 3.00

RM13.60 3.00

RM 5.60

Earnings before tax (EBT) Less: Tax (40%)

RM 5.00 2.00

RM10.60 4.24

Earnings after tax (EAT) RM 3.00 RM 6.36 RM 3.36

Change is sales Change in EBIT Change in EAT, hence EPS with no preferred dividends

RM14.00 / RM70.00 = RM 5.60 / RM 8.00 = RM 3.36 / RM 3.00 =

20.00% 70.00%

112.00%

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Another approach in calculating the DFL is based on units of production or

sales as follows:

DFLU = (70 (1 – 0.60) – 20) / (70 (1 – 0.60) – 20 – 3)

= 1.60x

DFLS = (70 – 42 – 20) / (70 – 42 – 20 – 3)

= 1.60x

The analysis of leverage, DOL and DFL shows that:

1. The higher DOL or fixed operating cost, the more sensitive EBIT due

to change in sales; and

2. The higher DFL or fixed financial cost, the more sensitive EPS due to

change in EBIT.

Therefore, the net effect of any change in sales is significant to EPS and, thus

returns to common stockholders.

DFLU = (Q (P – V) – FC) / (Q (P – V) – FC – I) or, based on Ringgit sales: DFLS = (S – VC – FC) / (S – VC – FC – I) Where Q : Sales quantity units

P : Price per unit

V : Variable cost per unit

FC : Total fixed cost

I : Interest

VC : Total variable costs in RM that equals to QV

S : Sales revenue in RM that equals to QP

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10.3 DEGREE OF TOTAL LEVERAGE To determine the overall impact of leverage, the following formula for total degree of total leverage (DTL) utilizes both DOL and DFL is as follows:

DTL = DOL (DFL)

= 3.50 (1.60)

= 5.60x

Alternatively, by using the simplified equation that combined both DOL and DTL:.

DTLU = Q (P – V) / (Q (P – V) – FC – I)

= 70(1 – 0.60) / (70(1 – 0.60) – 20 – 3)

= 5.60x

DTLS = (S – VC) / (S – VC – FC – I)

= (70 – 42) / (70 – 42 – 20 – 3)

= 5.60x

The degree of total leverage shows that; if Marisa's sales increase by 1% then the earnings

per share will increase by 5.60%, and vice versa. The use DTL could provides an easy way

to estimate the expected earnings per share given any change in sales. To illustrate, let

assume that current EPS for Marisa's is RM0.30 and sales to increase by 20 %. Therefore,

the EPS1 for the next period equals to:

EPS1 = Current EPS (1 + [(Degree of total leverage)(Percentage change is sales)])

= EPS0 (1.0 + [(DTL)(∆S)])

= 0.30 (1.0 + (5.60)(0.20))

= RM0.64

The above calculations for DFL and DTL assume that the firm has no preferred stock. To

account for preferred stock dividends, the above formulas should be adjusted appropriately

by deducting before tax value of preferred stock dividends. For example, if Marisa's

preferred dividends is RM1,000; new DFLS for the company:

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DFLS = S – QV – FC / (S – QV – FC – I – (Dps / (1 – T))

Where Dps : Preferred stock dividends

T : Marginal tax rate

DFLS = 70 – 42 – 20 / 70 – 42 – 20 – 3 – (1 / (1 – 0.4))

= 2.40x

DTLS = S – VC / S – VC – FC – I – (Dps / (1 – T))

= 70 – 42 / 70 – 42 – 20 – 3 – (1 / (1 – 0.4))

= 8.41x

With the presence of preferred dividends, the firm's leverage tends to increase that

represent an increase in the level of financial risk. Another measure to evaluate the risk is by

looking at the Financial Break-even (FBE) and Fixed Payment Ratio (FPR) of the firm.

Financial break-even is the amount of EBIT necessary to cover the fixed financial obligations

such as interest on debt and dividends on preferred stock. Marisa's financial break-even and

fixed payment ratios are as follows:

FBE = I + (Dps / (1 – T))

= 3 + (1 / (1 – 0.4))

= RM4.67

FPR = FBE / EBIT

= 4.67 / 8

= 58.38%

For financial break-even and fixed financial ratio, lower values are preferable as it indicates

lower fixed financial obligations relative to EBIT, and therefore represent lower financial risk

and overall risks.

10.4 POINT OF INDIFFERENCE Previous sections analyze the impact of alternative investments in fixed assets and financing

alternatives, particularly with debt on the firm's earnings per share. At any point of time, it is

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to the best interest of the firm to adopt sound financial decisions, such as optimal financing

mixes to maximize the firm's value; a measure of EPS. The proper financing mixes are

important as too many debts will result in:

1. Increasing interest charges;

2. Reduce the earnings after tax; and

3. Results in higher EPS as there is less common equity outstanding.

On the other hand, too much equity results in higher earnings after tax but low EPS as the

number of common shares outstanding are substantially large.

In any financing mix, there is a point of EBIT where the level of EPS is equal. The level of

associate EBIT or point of indifference (POI) is determines by finding the level of EBIT that

provides the same EPS for the alternative financing plans by using the following equation:

To illustrate, the Versatile Berhad with the following capital structure: (1) RM300,000 of debt

at 10%; and (2) RM600,000 common stock with par of RM10. The company plans to raise

another RM300,000 to finance a new project next year, and the following two alternatives of

financing are available:

X. to issue RM1,000 bond par value with coupon rate of 12% per annum at par for the

entire RM300,000; or

Y. to issue new common stocks at RM25.00 each including RM5.00 for underwriting

and brokerage fees.

If the firm's marginal tax rate 30%, what is the POI? The process of determining the POI

involves the following steps:

EPS plan1 = EPS plan2

((⊕EBIT – I1)(1 – T) – Dps1) / N1 = ((⊕EBIT – I2)(1 – T) – Dps2) / N2

Where ⊕EBIT : The unknown indifference point of EBIT

I1,2 : The annual interest charges

T : The firm's marginal tax rate

Dps1,2 : Annual preferred dividends

N1,2 : The number of common shares outstanding

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1. Calculate current key financial data

Interest on debt = Value of Debt (Cost of debt)

= 300,000 (0.10)

= RM30,000

Preferred dividends = None

Number of Common Shares= Common stock value / Par value

= 600,000 / 10.00

= 60,000 shares

2. Calculate the expected key financial data for each proposal

X. Interest on debt = (Debt Financing / Net proceeds)(Par)(Costs of debt)

= (300,000 / 1,000)(1,000)(0.12)

= RM36,000

Preferred dividends = None

Number of Common Shares = None

Y. Interest on debt = None

Preferred dividends = None

Number of Common Shares = Common stock Financing / net proceeds

= 300,000 / (25.00 – 5.00)

= 15,000 shares

3. Determine the new key financial data for each proposal: The projected values

equal to values in Step 1 plus Step 2 for each financing source.

X. Interest on debt = 30,000 + 36,000

= RM66,000

Preferred dividends = None

Number of Common Shares = 60,000 shares + 0

= 60,000 shares

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Y. Interest on debt = 30,000 + 0

= RM30,000

Preferred dividends = None

Number of Common Shares = 60,000 shares + 15,000 shares

= 75,000 shares

4. Substitute the key financial data in the base formula

((⊕EBIT – IX)(1 - T) – DpsX) / NX = ((⊕EBIT – IY)(1 - T) – DpsY] / NY

((⊕EBIT – 66.0)(1 – 0.3) – 0) / 60.0 = ((⊕EBIT – 30.0)(1 – 0.3) – 0] / 75.0

(0.7⊕EBIT – 46.2) / 60.0 = (0.7⊕EBIT – 21.0) / 75.0

0.7⊕EBIT – 46.2 = (60.0 / 75.0) (0.7⊕EBIT – 21.0)

0.7⊕EBIT – 46.2 = (60.0 / 75.0) (0.7⊕EBIT – 21.0)

0.7⊕EBIT – 46.2 = 0.80 (0.7⊕EBIT – 21.0)

0.7⊕EBIT – 46.2 = 0.56⊕EBIT – 16.8

0.7⊕EBIT – 0.56⊕EBIT = 46.2 – 16.8

0.14⊕EBIT = 29.4

⊕EBIT = RM210.0

For the above example, POI equals to RM210,000. At this point both plans X and Y

will give the same EPS. Either one of the plan is acceptable if the firm expects to

have EBIT of RM210,000 next year. To prove this let substitute ⊕EBIT with

RM210,000:

EPS Plan X = EPS Plan Y

((210.0 – 66.0)(0.7) – 0) / 60.0 = ((210.0 – 30.0)(0.7) – 0) / 75.0

RM100.8 / 60.0 = RM126.0 / 75.0

RM1.68 = RM1.68

Therefore, at EBIT of RM210,000, both financing plans give the same EPS of

RM1.68, and the firm can adopt either one of the alternatives.

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The above example can be depicted in the EBIT-EPS graph to provide more understanding

of the concept behind the point of indifference. To develop the EBIT-EPS analysis, we need

two reference data points; one at the lower end of EBIT and the other one are at higher end

of EBIT for each of the two financing plans.

It can be set arbitrarily; for example, the lower end EBIT can be set at RM100,000 and the

higher end at RM300,000. At EBIT equals RM100,000:

EPSX = ((100.00 – 66.00)(1 – 0.3) – 0.00) / 60.00

= RM0.3967

EPSY = ((100.00 – 30.00)(1 – 0.3) – 0.00) / 75.00

= RM0.6533

Therefore, the first reference point for each financing plan can be plotted as shown in Figure

8-1. However, it is advisable to set the first reference point at EBIT that are needed to cover

all fixed financing costs such as interest and preferred dividends for each financing plan.

This is the point known as financial break even (FBE) and defined as:

FBE = I + (Dps / (1 – T)

Where I : Interest payments in RM

Dps : Preferred stock dividends in RM

T : Corporate tax rate

At this point EPS equal zero. As such EBIT:

FBE for plan X = 66.00 + (0.00 / ( 1 – 0.30)

= 66.00

FBE for plan Y = 30.00 + (0.00 / ( 1 – 0.30)

= 30.00

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2.52

-0.28

0.65

1.59

-1.00-0.500.000.501.00

1.502.002.503.00

0 100 200 300

EBIT (R M )

EP

S P lan XP lan Y

The next step is to calculate EPS at second reference point, at EBIT of RM310,000. The

corresponding EPS are then calculated as follows:

EPSX = ((300.00 – 66.00)(1 – 0.3) – 0.00) / 60.00

= RM2.73

EPSY = ((300.00 – 30.00)(1 – 0.3) – 0.00) / 75.00

= RM2.52

With the above information, the characteristic line of EBIT-EPS for each financing alternative

can be plotted and drawn to determine the point of indifference between the two financing

alternative as shown in Figure 10.3.

Figure 10.3 EBIT-EPS Chart for Plan X and Plan Y

The point of intercept between the line at EBIT RM210,000 and EPS of RM1.68 represent

the indifference point between the alternatives financing plans. At EBIT level of RM210,000

and above, financing plan X provides higher EPS than financing plan Y. On the other hand,

at EBIT of less than RM210,000, financing plan Y provides higher EPS than financing plan

X. Which plan is the best for the firm? The answer will depend on the firm’s expected EBIT.

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For example, if the firm’s expected EBIT is RM200,000, therefore it is best for the firm to

adopt financing plan Y as it will provides the higher EPS. To substantiate this, at EBIT

RM200,000:

EPSX = (200.0 – 66.0)(0.7) – 0 / 60.0

= RM1.56

EPSY = (200.0 – 30.0)(0.7) – 0 / 75.0

= RM1.59

Therefore, the firm should choose plan Y as it will result in higher EPS. This analysis

provides the management the basis of financial planning and forecasting in deciding a

proper financing mix that leads to increase of the owners' wealth.

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QUESTION 1

Besta Corporation is trying to decide how best to finance a proposal RM20 million

capital investment. Under Plan 1, the project will be financed entirely with long-term

10% bonds. The currently has no debt or preferred stock. Under Plan 2, common

stock will be sold to net the firm RM20 a share. At present 1 million shares are

outstanding. The corporate tax rate for the company is 40%.

a) Calculate the indifference level of EBIT associated with the two financing

plans.

b) Prepare an EBIT-EPS analysis chart, showing the intersection of two

financing plans line.

c) Which financing plan would you expect to cause the greatest change in EPS

relative to a change in EBIT?

d) If EBIT is expected to be RM4.5 million, which plan will result in a higher

EPS? (Show the calculation of EPS for both plans)

(6+7+2+5=20 marks)

QUESTION 2 a) What is meant by “capital structure” of a firm? Describe briefly two ratios that

will provide an assessment of the degree of financial leverage in a firm’s

capital structure.

(6 marks)

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b) SA Corporation is considering on two possible capital structures – Structure A

and Structure B. The key information is shown in the following table.

Source of capital Structure A Structure B

Long-term debt RM150,000 @ 15%

interest

RM100,000 @ 13%

interest

Preferred stock RM20,000 @ 16%

dividend

RM30,000 @ 16%

dividend

Common stock 15,000 shares 20,000 shares

Assuming an income tax rate of 40%, calculate the EPS for each structure if

earnings before interest and tax (EBIT) are at RM120,000.

(14 marks)

QUESTION 3

Big Bear Company is considering purchasing an equipment for the business. The

purchase would be financed by two sources of capital, long – term debt and common

stocks. Given below are the two alternative capital structures with an assumption of

40% tax rate.

Source of Capital Structure 1 Structure 2 Long – term debt RM500,000 at 8% RM350,000 at 7%

Common stock 10,000 shares 20,000 shares

a) What is the financial breakeven point for each structure?

(4 marks)

b) What is the EPS under each structure if the firm projects EBIT of RM50,000?

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(6 marks)

c) At about what EBIT level should the financial manager be indifferent to either

capital structure?

(7 marks)

d) Which capital structure has a higher degree of financial risk? Why?

(3 marks)

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