lecture note prof. roy sembel, phd leverage and capital structure

Lecture NoteProf. Roy Sembel, PhD

Leverage andCapital Structure

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

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.

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.

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.

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

Fixed vs. Variable CostsFixed vs. Variable Costs

Fixed costs may include salaries, depreciation, rent.

Variable costs may include commissions, materials, labor.


Calculation of Break-even Quantity

EBIT = Sales – Variable Costs - Fixed Costs

Find Quantity which results in EBIT = $0Find Quantity which results in EBIT = $0



Unit Salesbe = FC p – vc

Where:Unit Salesbe = Break-even quantity

FC = Total fixed costsp = Sales price per unit

vc = Variable costs per unit




Example:Fixed Costs = $1,000,000/yearPrice = $800/unitVariable Costs = $400/unit




Example:Fixed Costs = $1,000,000/yearPrice = $800/unitVariable Costs = $400/unit

$1,000,000 $800 – $400

=

= 2,500 units


Now calculate total revenue.

TR = p x Q

p = Sales price per unitQ = unit sales


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

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



Quantity of Units

Sales &

Costs$


Total Costs

Variable Costs



Quantity of Units

Sales &

Costs$


Total Costs

Sales

Variable Costs



Quantity of Units

Sales &

Costs$


Total Costs

Variable Costs

Sales

Qbe = 2,500

$2,000,000

The Concept of LeverageThe Concept of LeverageYou cannot easily move a large boulder.

The Concept of LeverageThe Concept of Leverage

However, with the aid of a lever you can move an object many times your size.


The longer the lever, the bigger therock you can move.


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).

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

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

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:



DOL3,750 units = 3,750(800) – 3,750(400) 3,750(800) –3,750(400) – 1,000,000




DOL3,750 units =

= 3

3,750(800) – 3,750(400) 3,750(800) –3,750(400) – 1,000,000


Interpretation: If sales change 1%, then EBIT will change 3% (same direction).

Interpretation: If sales change 1%, then EBIT will change 3% (same direction).

Operating LeverageOperating LeverageDegree of Operating Leverage falls

as sales rise

Quantity DOL2,500 (Qbe) Undefined3,250 4.333,750 35,000 2

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

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.



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

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.


EBIT = $500,000Interest Charges = $200,000

Example:



Example:

DFLEBIT=500,000 = 500,000 500,000 – 200,000

= 1.67 times



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%

Combined LeverageCombined LeverageDegree of Combined Leverage

Measures changes in Net Income given changes in Sales



Combines both Operating and Financial Leverage



Combines both Operating and Financial LeverageComputed for a specific level of sales

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


DCLS = DOLS x DFLEBIT

DFLEBIT = 1.67 DOLS = 3.0

Example:Example:




Example:Example:

= 5.0 times

DCL3,750 = 3.0 x 1.67




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

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.

Capital Structure TheoryCapital Structure Theory

Capital Structure is the mixture of sources of funds a firm uses.DebtPreferred StockCommon Stock

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.

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.

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.)

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

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

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

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

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

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

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:

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.

lecture note prof. roy sembel, phd leverage and capital structure

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