lecture note prof. roy sembel, phd leverage and capital structure
TRANSCRIPT
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Lecture NoteProf. Roy Sembel, PhD
Leverage andCapital Structure
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PROF. ROY SEMBELEDUCATION1982-86 IPB, Bogor. FMIPA. Major: Statistics, Minor: Economics; Ir., Best Graduate, Cum
Laude 1988-90 Rotterdam School of Management, Erasmus University Rotterdam and The Wharton
School, University of Pennsylvania PhiladelphiaMBA, Finance/Banking, Best Graduate, With Honours
1991-96 J.M.Katz Graduate School of Business, University of Pittsburgh; Major: Corporate Finance; Minor: Econometrics; PhD; Dissertation: “IPO Anomalies, Truncated Excess Supply, and Heterogeneous Information”
1997-98 Economics & Finance Staff, Office of Dr (HC) Radius Prawiro, Jakarta.2000 ACUCA Lecturer: Japan, South Korea, Taiwan, Hong Kong, The Philippines, Thailand1987-Now Lecturer, Faculty of Economics, Christian University of Indonesia, Jakarta.1997-2001 Visiting Lecturer at IPMI, Institut PPM, Magister Management Program University of Indonesia, University of Sam Ratulangi, Universitas Lampung, Magister Akuntansi & Post Graduate (S2 & S3) Program Faculty of Economics University of Indonesia, Pelita Harapan University. Subjects: Investment Analysis and Risk Management, Corporate Finance, International Finance, Derivative Securities, Managerial Economics, Banks & Capital Markets, eBusiness Management.
WORK EXPERIENCE1984-87 Teaching Assistant, FMIPA, IPB.1990 Internship; ABN Bank, European Treasury Department, Amsterdam.1990-91 Corporate Banking; ABN AMRO Bank Amsterdam1994-96 Teaching Assistant, University of Pittsburgh.1994-2000 Co-founder Indonesian Physics Olympic Team /TOFI Foundation & Indonesian Computer Olympic Foundation TOKI
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1998-2001 McKinsey & Co, Jakarta2001-2006 Direktur Program Magister Manajemen Keuangan Universitas Bina Nusantara, Co-founder Indonesia Learning Institute (InLIne), Indonesia School of Life (InSchoOL)2005-2007 Komisaris Independen & Ketua Komite Pemantau Risiko PT Bank Niaga Tbk2005- Professor in Financial Economics;
Charter member Lembaga Komisaris dan Direksi Indonesia2006-2008 Academic Expert Advisor, Universitas Ciputra Surabaya, 2006- Owner/Komisaris (PT. Mobee Indonesia, PT MARS Indonesia)2007- Supervisory Committee Asian Bond Fund Indonesia (TCW Bahana/BI),
Ketua Komite Sertifikasi FPSB Indonesia 2007-2008 Pejabat Dekan FE Universitas Multimedia Nusantara (UMN)
Ketua Umum Partai Barisan Nasional (BARNAS)2008 Board of Advisor UMN2008- Ketua Dewan Pembina Partai Barisan Nasional (BARNAS)
Chief Research Officer CAPITAL PRICE2009- Dean of Business School and Director of Graduate Program, UPH
MISCELLANEOUS Speaker in many seminars in Indonesia, USA, and Europe. Writer of more than 1000 articles in KONTAN, GATRA, Sinar Harapan, SWA, Bisnis Indonesia, KOMPAS, Investor, Investor Daily, Warta Ekonomi, Manajemen & Usahawan Indonesia, InfoBank, Jurnal Pasar Modal, Media Akuntansi, DIA, Bahana, Jurnal Ekonomi UKI, JAKI, JBR, Scripta Economica UPH, Jurnal, Sinergi MMUII, published books, Internet.
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Learning ObjectivesLearning Objectives
Break-even level of sales.Operating and financial leverage
and risk.Risks and returns of leveraged
buy-outs.Affect of capital structure on value.
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Break-even AnalysisBreak-even Analysis
Steps to SolutionConstruct a chart to find the sales break-
even point = level of sales necessary to cover operating (not financial) costs.
This requires that you calculate EBIT for different unit sales amounts.
The point at which EBIT = 0 is the break-even level of sales.
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Break-even AnalysisBreak-even AnalysisAssumptions Fixed costs remain constant as quantity changes. Variable costs vary as quantity of output
changes: they are constant per unit of output.
Quantity Sold
Costs$
Fixed Costs
Variable Costs
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Fixed vs. Variable CostsFixed vs. Variable Costs
Fixed costs may include salaries, depreciation, rent.
Variable costs may include commissions, materials, labor.
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Break-even AnalysisBreak-even Analysis
Calculation of Break-even Quantity
EBIT = Sales – Variable Costs - Fixed Costs
Find Quantity which results in EBIT = $0Find Quantity which results in EBIT = $0
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Break-even AnalysisBreak-even Analysis
Calculation of Break-even Quantity
Unit Salesbe = FC p – vc
Where:Unit Salesbe = Break-even quantity
FC = Total fixed costsp = Sales price per unit
vc = Variable costs per unit
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Break-even AnalysisBreak-even Analysis
Calculation of Break-even Quantity
Unit Salesbe = FC p – vc
Example:Fixed Costs = $1,000,000/yearPrice = $800/unitVariable Costs = $400/unit
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Break-even AnalysisBreak-even Analysis
Calculation of Break-even Quantity
Unit Salesbe = FC p – vc
Example:Fixed Costs = $1,000,000/yearPrice = $800/unitVariable Costs = $400/unit
$1,000,000 $800 – $400
=
= 2,500 units
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Break-even AnalysisBreak-even Analysis
Now calculate total revenue.
TR = p x Q
p = Sales price per unitQ = unit sales
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Break-even AnalysisBreak-even Analysis
Calculate total revenue for different levels of sales.
TR = p x Q
Unit sales (Q) x Price (p) = Total Revenue (TR) 0 x $800 = $0
500 x $800 = $ 400,0001,000 x $800 = $ 800,0002,000 x $800 = $1,600,0002,500 x $800 = $2,000,000
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Break-even Analysis-GraphBreak-even Analysis-Graph
Graphical Analysis of Break-even Point
Quantity of Units
Sales &
Costs$
Fixed Costs $1,000,000
Variable Costs
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Break-even Analysis-GraphBreak-even Analysis-Graph
Graphical Analysis of Break-even Point
Quantity of Units
Sales &
Costs$
Fixed Costs $1,000,000
Total Costs
Variable Costs
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Break-even Analysis-GraphBreak-even Analysis-Graph
Graphical Analysis of Break-even Point
Quantity of Units
Sales &
Costs$
Fixed Costs $1,000,000
Total Costs
Sales
Variable Costs
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Break-even Analysis-GraphBreak-even Analysis-Graph
Graphical Analysis of Break-even Point
Quantity of Units
Sales &
Costs$
Fixed Costs $1,000,000
Total Costs
Variable Costs
Sales
Qbe = 2,500
$2,000,000
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The Concept of LeverageThe Concept of LeverageYou cannot easily move a large boulder.
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The Concept of LeverageThe Concept of Leverage
However, with the aid of a lever you can move an object many times your size.
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The Concept of LeverageThe Concept of Leverage
The longer the lever, the bigger therock you can move.
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The Concept of LeverageThe Concept of Leverage
In a financial context, the magnifying power of leverage can be used to help (or hurt) a firm’s financial performance.
Operating leverage occurs due to fixed costs in the production process.
With high fixed costs, a small change in sales may trigger a large change in operating income (EBIT).
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Operating LeverageOperating Leverage
Measurement of Operating LeverageDegree of Operating Leverage (DOL)
DOL > 1 means the firm has operating leverage.
DOL = % Change in EBIT % Change in Sales
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Operating LeverageOperating Leverage
DOL = % Change in EBIT % Change in Sales
Example: fixed costs = $1 and no variable costs EBIT for Sales of $3 = $3 - $1 = $2 EBIT for Sales of $4 = $4 - $1 = $3
($3 - $2)/$2 .50($4 - $3)/$3 .33DOL = = = 1.5
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Operating LeverageOperating LeverageMeasurement of DOL
Calculation using per unit information:
DOL = Sales - Total VC Sales-Total VC-FC
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Operating LeverageOperating LeverageMeasurement of DOL
Calculation using per unit information:
DOL = Sales - Total VC Sales-Total VC-FC
Q = 3,750 unitsP = $800 per unit
VC = $400 per unit FC = $1,000,000 per year.
Example:Example:
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Operating LeverageOperating LeverageMeasurement of DOL
Calculation using per unit information:
DOL3,750 units = 3,750(800) – 3,750(400) 3,750(800) –3,750(400) – 1,000,000
DOL = Sales - Total VC Sales-Total VC-FC
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Operating LeverageOperating LeverageMeasurement of DOL
Calculation using per unit information:
DOL3,750 units =
= 3
3,750(800) – 3,750(400) 3,750(800) –3,750(400) – 1,000,000
DOL = Sales - Total VC Sales-Total VC-FC
Interpretation: If sales change 1%, then EBIT will change 3% (same direction).
Interpretation: If sales change 1%, then EBIT will change 3% (same direction).
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Operating LeverageOperating LeverageDegree of Operating Leverage falls
as sales rise
Quantity DOL2,500 (Qbe) Undefined3,250 4.333,750 35,000 2
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Operating LeverageOperating LeverageDegree of Operating Leverage falls
as sales rise
Quantity DOL2,500 (Qbe) Undefined3,250 4.333,750 35,000 2
The higher the sales level above break-even, the less EBIT changes as sales change
If FC = $0, DOL = 1
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Financial LeverageFinancial LeverageDegree of Financial Leverage
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Financial LeverageFinancial LeverageDegree of Financial Leverage
Finance a portion of the firm’s assets with securities that have fixed financial costsDebtPreferred Stock
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Financial LeverageFinancial LeverageDegree of Financial Leverage
Finance a portion of the firm’s assets with securities that have fixed financial costsDebtPreferred Stock
Financial Leverage measures changes in earnings per share as EBIT changes.
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Financial LeverageFinancial LeverageDegree of Financial Leverage
Finance a portion of the firm’s assets with securities that have fixed financial costsDebtPreferred Stock
Financial Leverage measures changes in earnings per share as EBIT changes.
DFLEBIT = % Change in NI % Change in EBIT
Unique Level of EBITUnique Level of EBIT
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Financial LeverageFinancial Leverage
DFLEBIT = EBIT EBIT – I
Measurement of DFL (Alternative formula)
If DFL > 1, the firm has financial leverage. An increase in EBIT wil result in a larger increase in NI.
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Financial LeverageFinancial Leverage
EBIT = $500,000Interest Charges = $200,000
Example:
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Financial LeverageFinancial Leverage
EBIT = $500,000Interest Charges = $200,000
Example:
DFLEBIT=500,000 = 500,000 500,000 – 200,000
= 1.67 times
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Financial LeverageFinancial Leverage
EBIT = $500,000Interest Charges = $200,000
Example:
DFLEBIT=500,000 = 500,000 500,000 – 200,000
= 1.67 times
Interpretation: When EBIT changes 1% (from an existing level of $500,000) Earnings Per Share will change 1.67%
Interpretation: When EBIT changes 1% (from an existing level of $500,000) Earnings Per Share will change 1.67%
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Combined LeverageCombined LeverageDegree of Combined Leverage
Measures changes in Net Income given changes in Sales
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Combined LeverageCombined LeverageDegree of Combined Leverage
Measures changes in Net Income given changes in Sales
Combines both Operating and Financial Leverage
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Combined LeverageCombined LeverageDegree of Combined Leverage
Measures changes in Net Income given changes in Sales
Combines both Operating and Financial LeverageComputed for a specific level of sales
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Combined LeverageCombined Leverage
DCLS = % Change in EPS % Change in Sales
Degree of Combined LeverageMeasures changes in Net Income given changes
in SalesCombines both Operating and Financial LeverageComputed for a specific level of sales
Unique Level of SalesUnique Level of Sales
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Combined LeverageCombined Leverage
DCLS = DOLS x DFLEBIT
DFLEBIT = 1.67 DOLS = 3.0
Example:Example:
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Combined LeverageCombined Leverage
DCLS = DOLS x DFLEBIT
DFLEBIT = 1.67 DOLS = 3.0
Example:Example:
= 5.0 times
DCL3,750 = 3.0 x 1.67
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Combined LeverageCombined Leverage
DCLS = DOLS x DFLEBIT
DFLEBIT = 1.67 DOLS = 3.0
Example:Example:
= 5.0 times
Interpretation: When sales change 1%, Net Income will change 5.0%
Interpretation: When sales change 1%, Net Income will change 5.0%
DCL3,750 = 3.0 x 1.67
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Effect of LeverageEffect of Leverage
Leverage can help the firm or hurt it. If EBIT increases, leverage will cause
net income to increase even more.If EBIT decreases, leverage will
cause a larger decline in net income.
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Capital Structure TheoryCapital Structure Theory
Capital Structure is the mixture of sources of funds a firm uses.DebtPreferred StockCommon Stock
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Capital Structure TheoryCapital Structure Theory
A benefit of debt financing is that interest is tax deductible whereas payments to equity providers are not.
Firms must trade off this benefit against the increased financial risk associated with higher debt levels.
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Capital Structure TheoryCapital Structure Theory-Modigliani and Miller (MM)-Modigliani and Miller (MM)
MM wrote an important paper in 1958 in which they proved that with tax deductibility of interest payments, the optimal capital structure is 100% debt.
Assumptions: No transaction costs, no taxes, everyone has same information and borrowing rates, debt is riskless, debt does not affect operations.
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Financial Leverage, EPS, and ROE Financial Leverage, EPS, and ROE
CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50
Proposed$20,000
$8,000$12,000
2/38%240$50
Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)
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EPS and ROE Under Current Capital StructureEPS and ROE Under Current Capital StructureRecessionExpectedExpansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
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EPS and ROE Under Proposed Capital StructureEPS and ROE Under Proposed Capital StructureRecessionExpectedExpansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares
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EPS and ROE Under Both Capital EPS and ROE Under Both Capital StructuresStructures
LeveredRecession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares
All-EquityRecession Expected Expansion
EBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400 shares
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Financial Leverage and EPSFinancial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
EP
S
Debt
No Debt
Break-even point
EBI in dollars, no taxes
Advantage to debt
Disadvantage to debt EBIT
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Total Cash Flow to Investors Under Total Cash Flow to Investors Under Each Capital Structure with Corp. TaxesEach Capital Structure with Corp. Taxes
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.
S G S G
B
All-equity firm Levered firm
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Integration of Tax Effects and Financial Distress CostsIntegration of Tax Effects and Financial Distress Costs
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL = VU + TCB
V = Actual value of firm
VU = Value of firm with no debt
B*
Maximumfirm value
Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt.
Optimal amount of debt
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Capital Structure in the Real WorldCapital Structure in the Real World
Firms attempt to balance the costs and benefits of debt to reach the optimal mix that maximizes the value of the firm.
Affect on costs of capital:
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Capital Structure in the Real WorldCapital Structure in the Real World
Firms attempt to balance the costs and benefits of debt to reach the optimal mix that maximizes the value of the firm.
Affect on costs of capital:Since debt is cheaper than equity, use
of debt will initially lower the WACC.At high levels of debt, the WACC will
increase as investors perceive the firm to be riskier.