Long-term financing

decisions
Basic concept & objective of capital structure
• Cost of Capital– Rate of return that is necessary to maintain the market value of
the firm, or the price of the firm’s stock.
• Optimal capital structure – strikes the optimal balance between risk and return and
thereby maximizing the price of the stock.
 Capital Structure Policy
• This involves a tradeoff between risk and return
• Objective is to mix the permanent sources of funds in a manner that will maximize
the company’s common stock price or minimize its total cost of capital
 Factors Influencing Capital Structure
1. Business risk – uncertainty inherent in projections of future returns on assets or (ROE),
assuming the firm uses no debt.
Most common factors affecting business risk are:
• Demand variability
• Same price variability
• Input price variability
• Ability to adjust output prices for changes in input prices
• Degree of operating leverage of the form or the extent to which costs are fixed.
 Factors Influencing Capital Structure
2. Financial risk – portion of the stockholders’ risk, over and above basic business
risk, resulting from the use of financial leverage
3. Effect on taxes (income taxes) – interest is a deductible expense, and deductions
from income subject to income taxes usually make the difference ind eciding
capital structure
4. Financial flexibility – ability the firm to raise capital on reasonable terms under
difficult times or adverse conditions
5. Management capabilities to forecast market conditions
 Basic Tools of Capital Structure Management
• Financial Structure – mix of items on the right-hand side of the firm’s balance
sheet or its total liabilities and some equity section.
• Total financial structure – total current liabilities = total capital structure.
The Firm’s Capital Structure
 Basic Tools of Capital Structure Management
• Leverage – cost of structure, in which the fixed costs represent a risk to the firm
- Leverage is composed of operating and financial leverage
a. Operating leverage- used to measure operating risk, which refers to the fixed
operating costs
- responsiveness of a firm’s EBIT to fluctuations in sales
 Basic Tools of Capital Structure Management
b. Financial leverage – used to measure of financial risk, which refers to financing a
portion of the firm’s assets, bearing fixed financing charges, such as the interest
expense in debt financing.
• The higher the financial leverage, the higher the financial risk, and the higher
the cost of capital
c. Combining operating and financial leverage – changes in sales revenues causes
greater changes in EBIT
Leverage
• Leverage results from the use of fixed-cost assets or
funds to magnify returns to the firm’s owners.
• Generally, increases in leverage result in increases in
risk and return, whereas decreases in leverage result
in decreases in risk and return.
• The amount of leverage in the firm’s capital structure—
the mix of debt and equity—can significantly affect its
value by affecting risk and return.
Leverage (cont.)
Operating Leverage
Operating Leverage: Measuring the
Degree of Operating Leverage
• The degree of operating leverage (DOL)
measures the sensitivity of changes in EBIT to
changes in Sales.
• A company’s DOL can be calculated in two
different ways: One calculation will give you a
point estimate, the other will yield an interval
estimate of DOL.
• Only companies that use fixed costs
in the production process will experience
operating leverage.
Operating Leverage: Measuring the
Degree of Operating Leverage (cont)
DOL = Percentage change in EBIT
Percentage change in Sales

• Applying this equation to cases 1 and 2 in

Table 12.4 yields:
Case 1: DOL = (+100% ÷ +50%) = 2.0

Case 2: DOL = (-100% ÷ -50%) = 2.0

Operating Leverage: Measuring the
Degree of Operating Leverage (cont)
• A more direct formula for calculating DOL
at a base sales level, Q, is shown below.
DOL at base Sales level Q = Q X (P – VC)
Q X (P – VC) – FC

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500

yields the following result:

DOL at 1,000 units = 1,000 X ($10 - $5) = 2.0

1,000 X ($10 - $5) - $2,500
Operating Leverage: Fixed Costs
and Operating Leverage
Assume that Cheryl’s Posters exchanges a portion of its
variable operating costs for fixed operating costs by
eliminating sales commissions and increasing sales
salaries. This exchange results in a reduction in variable
costs per unit from $5.00 to $4.50 and an increase in
fixed operating costs from $2,500 to $3,000

DOL at 1,000 units = 1,000 X ($10 - $4.50) = 2.2

1,000 X ($10 - $4.50) - $3,000
Operating Leverage: Fixed Costs
and Operating Leverage (cont.)
Financial Leverage
• Financial leverage results from the presence of fixed
financial costs in the firm’s income stream.
• Financial leverage can therefore be defined as the
potential use of fixed financial costs to magnify the
effects of changes in EBIT on the firm’s EPS.
• The two fixed financial costs most commonly found on
the firm’s income statement are (1) interest on debt and
(2) preferred stock dividends.
Financial Leverage (cont.)
Chen Foods, a small Oriental food company, expects EBIT of
$10,000 in the current year. It has a $20,000 bond with a
10% annual coupon rate and an issue of 600 shares of $4
annual dividend preferred stock. It also has 1,000 share of
common stock outstanding.

The annual interest on the bond issue is $2,000 (10% x

$20,000). The annual dividends on the preferred stock are
$2,400 ($4/share x 600 shares).
Financial Leverage (cont.)
Financial Leverage: Measuring the
Degree of Financial Leverage
• The degree of financial leverage (DFL)
measures the sensitivity of changes in EPS to
changes in EBIT.
• Like the DOL, DFL can be calculated in two
different ways: One calculation will give you a
point estimate, the other will yield an interval
estimate of DFL.
• Only companies that use debt or other forms of
fixed cost financing (like preferred stock) will
experience financial leverage.
Financial Leverage: Measuring the
Degree of Financial Leverage (cont)
DFL = Percentage change in EPS
Percentage change in EBIT

• Applying this equation to cases 1 and 2 in

Table 12.6 yields:
Case 1: DFL = (+100% ÷ +40%) = 2.5

Case 2: DFL = (-100% ÷ -40%) = 2.5

Financial Leverage: Measuring the
Degree of Financial Leverage (cont)
• A more direct formula for calculating DFL at a
base level of EBIT is shown below.
DFL at base level EBIT = EBIT
EBIT – I – [PD x 1/(1-T)]

Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and

the tax rate, T = 40% yields the following result:

DFL at $10,000 EBIT = $10,000

$10,000 – $2.000 – [$2,400 x 1/(1-.4)]

DFL at $10,000 EBIT = 2.5

Total Leverage
• Total leverage results from the combined
effect of using fixed costs, both operating
and financial, to magnify the effect of
changes in sales on the firm’s earnings
per share.
• Total leverage can therefore be viewed as
the total impact of the fixed costs in the
firm’s operating and financial structure.
Total Leverage (cont.)
Total Leverage: Measuring the
Degree of Total Leverage
DTL = Percentage change in EPS
Percentage change in Sales

• Applying this equation to the data Table

12.7 yields:

Degree of Total Leverage (DTL) = (300% ÷ 50%) = 6.0

Total Leverage: Measuring the
Degree of Total Leverage (cont.)
• A more direct formula for calculating DTL at a
base level of Sales, Q, is shown below.
DTL at base sales level = Q X (P – VC)
Q X (P – VC) – FC – I – [PD x 1/(1-T)]

Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I =

$20,000, PD = $12,000, and the tax rate, T = 40% yields the
following result:
DTL at 20,000 units = 20,000 X ($5 – $2)
20,000 X ($5 – $2) – $10,000 – $20,000 – [$12,000 x 1/(1-.4)]

DTL at 20,000 units = $60,000/$10,000 = 6.0

 Total Leverage: The Relationship of
Operating, Financial and Total Leverage

The relationship between the DTL, DOL, and DFL is

illustrated in the following equation:

DTL = DOL x DFL

Applying this to our previous example we get:

DTL = 1.2 X 5.0 = 6.0

 An Overview of the Cost of Capital
• The cost of capital acts as a link between the firm’s long-term
investment decisions and the wealth of the owners as determined by
investors in the marketplace.
• It is the “magic number” that is used to decide whether a proposed
investment will increase or decrease the firm’s stock price.
• Formally, the cost of capital is the rate of return that a firm must earn
on the projects in which it invests to maintain the market value of its
stock.
 The Basic Concept
• Why do we need to determine a company’s overall “weighted
average cost of capital?”
Assume the ABC company has the following investment opportunity:
- Initial Investment = $100,000
- Useful Life = 20 years
- IRR = 7%
- Least cost source of financing, Debt = 6%

Given the above information, a firm’s financial manger would be inclined to accept and
undertake the investment.
 The Basic Concept (cont.)
• Why do we need to determine a company’s overall “weighted
average cost of capital?”
Imagine now that only one week later, the firm has another available investment
opportunity
- Initial Investment = $100,000
- Useful Life = 20 years
- IRR = 12%
- Least cost source of financing, Equity = 14%

Given the above information, the firm would reject this second, yet clearly more desirable
investment opportunity.
 The Basic Concept (cont.)
• Why do we need to determine a company’s overall “weighted average cost of
capital?”

• As the above simple example clearly illustrates, using this piecemeal approach to
evaluate investment opportunities is clearly not in the best interest of the firm’s
shareholders.
• Over the long haul, the firm must undertake investments that maximize firm value.
• This can only be achieved if it undertakes projects that provide returns in excess of
the firm’s overall weighted average cost of financing (or WACC).
 Determining the WACC:

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑥 (1 −𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)

1. Cost of Debt - 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡

𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
2. Cost of Preferred Stock - 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘𝑠
3. Cost of Common Stock - 𝑀𝑎𝑟𝑘𝑒𝑡
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑜𝑛 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘
+ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 𝑖𝑛 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

4. Cost of Retained Earnings = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 + (1 − 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠)
Breakeven Analysis
• Breakeven (cost-volume-profit) analysis is
used to:
– determine the level of operations necessary to cover
all operating costs, and
– evaluate the profitability associated with various
levels of sales.
• The firm’s operating breakeven point (OBP) is
the level of sales necessary to cover all
operating expenses.
• At the OBP, operating profit (EBIT) is equal to
zero.
Breakeven Analysis (cont.)

• To calculate the OBP, cost of goods sold and operating

expenses must be categorized as fixed or variable.
• Variable costs vary directly with the level of sales and
are a function of volume, not time.
• Examples would include direct labor and shipping.
• Fixed costs are a function of time and do not vary with
sales volume.
• Examples would include rent and fixed overhead.
Breakeven Analysis:
Algebraic Approach
• Using the following variables, the operating
portion of a firm’s income statement may be
recast as follows:
P = sales price per unit
Q = sales quantity in units
FC = fixed operating costs per period
VC = variable operating costs per unit

Letting EBIT = 0 and solving for Q, we get:

EBIT = (P x Q) - FC - (VC x Q)
Breakeven Analysis:
Algebraic Approach (cont.)
Q = FC
P - VC
Breakeven Analysis:
Algebraic Approach (cont.)
• Example: Cheryl’s Posters has fixed operating
costs of $2,500, a sales price of $10 per
poster, and variable costs of $5 per poster.
Find the OBP.
Q = $2,500 = 500 posters
$10 - $5
• This implies that if Cheryl’s sells exactly 500
posters, its revenues will just equal its costs
(EBIT = $0).
Breakeven Analysis:
Algebraic Approach (cont.)
• We can check to verify that this is the
case by substituting as follows:

EBIT = (P x Q) - FC - (VC x Q)

EBIT = ($10 x 500) - $2,500 - ($5 x 500)

EBIT = $5,000 - $2,500 - $2,500 = $0

Breakeven Analysis:
Graphical Approach
Breakeven Analysis: Changing Costs
and the Operating Breakeven Point

Assume that Cheryl’s Posters wishes to evaluate the impact

of several options: (1) increasing fixed operating costs to
$3,000, (2) increasing the sale price per unit to $12.50, (3)
increasing the variable operating cost per unit to $7.50, and
(4) simultaneously implementing all three of these changes.
 Breakeven Analysis: Changing Costs
and the Operating Breakeven Point
(1) Operating BE point = $3,000/($10-$5) = 600 units

(2) Operating BE point = $2,500/($12.50-$5) = 333 units

(3) Operating BE point = $2,500/($10-$7.50) = 1,000 units

(4) Operating BE point = $3,000/($12.50-$7.50) = 600 units

Breakeven Analysis: Changing Costs
and the Operating Breakeven Point