Capital Structure and the Effects of Leverage

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c) DETERMINE THE DEGREE OF OPERATING LEVERAGE FOR THE EXISTING PLAN AND THE PROPOSED PLAN.

Financial Risk (Leverage):

Financial Risk (leverage) can be defined as the degree to which a company uses fixed-income securities (i.e. debt). With a high degree of financial leverage comes higher interest payments. As a result, the earnings per share are negatively affected by these higher payments. Financial risk is the risk to the stockholders that is caused by an increase in debt in a company's capital structure.

Other things remaining equal, an increase in financial leverage will increase the equity beta of a firm.

When we increase the amount of debt financing, we increase the fixed interest expense. If we have a good year, them we pay our fixed costs (interest) and we have more left over for our shareholders.

If we have a bad year, we still have to pay our fixed costs (interest) and we have less left over for our shareholders.

As a company increases debt, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased.

A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt increase the value of the company.

-Don’t forget, financial leverage can increase EPS but it also increases the RISK.

-Financial leverage is the responsiveness of the earnings per share (EPS) or earnings available to common to fluctuations in EBIT

-The degree of financial leverage is defined as the %change in EPS that results from a % change in EBIT

[pic 2]

Example (Continued)

The Slumber Hat Company has decided that they will invest in the new facility because demand is expected to grow beyond the current capacity of the production facilities. The company must decide how to finance the $2,000,000 capital investment. Plan 1 calls for the project to be financed by issuing equity in the open market at $25 per share. Plan 2 calls for the project to be financed by 40% debt and 60% equity. The company’s market rate of interest on bonds of similar risk is 12% and the company is in a 42% tax bracket.

PLAN 1 PLAN 2

EBIT

Interest

Earnings before tax

Income tax (42%)

Earnings after tax

Shares Outstanding

EPS

a) What effect would a 10% change in EBIT have on the EPS of the company under the two plans?

PLAN 1 PLAN 2

EBIT

Interest

Earnings before tax

Income tax (42%)

Earnings after tax

Shares Outstanding

EPS

b) Determine the degree of financial leverage for the company under plan 1 and plan 2.

The Degree of Combined (Total) Leverage

The degree of combined leverage occurs when a firm has fixed operating costs and fixed financing costs. The degree of combined (total) leverage measures the effect a percentage change in sales will have on EPS.

[pic 3] or DCL = DOL * DFL

a) What is the DCL for Slumber Hat Company for Plans 1 and 2?

b) What is the effect of a 20% change in sales under plan 1 and 2?

The total risk exposure the firm assumes can be managed by combining operating and financial leverage in different degrees. If a high degree of business risk is inherent to the business, then the firm may want to minimize the financial risk in order to minimize earnings fluctuations.

Example #3: Birch Inc. has the following income statement (in millions of dollars):

Sales $50

Variable operating costs 24

Revenues before fixed operating costs 26

Fixed operating costs 13

EBIT 13

Interest 3

EBT 10

Taxes (30%) 3

EAT $ 7

*The firm as 1 million common shares outstanding

- At this level of sales, what is Birch Inc.’s degree of operating leverage?

- What is the degree of financial leverage?

- What is the degree of combined leverage?

- If sales should increase by 20%, by what percentage would EPS increase?

- What is the new level of EPS?

Example #4: Optics Inc. and Lenses Inc. are manufactures of contact lenses. The following income statements:

[pic 4]

- Calculate the degree operating leverage for each company.

- Calculate the degree of financial leverage for each company.

- Which company is riskier?

- If general market conditions improve by 20% and the firms are able to maintain their market share, what is the expected EPS for each of the firms?