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14
Introduction
This chapter focuses on the impact of leverage on corporate profits. We will cover:
Operating and financial leverage (pp. 472-475) Breakeven analysis (Appendix 14A) EBIT-EPS analysis (pp. 482-493)
Financial Leverage
Results from fixed capital costs such that a change in EBIT is magnified into a relatively large change in EPS
Benefits of leverage occur only within specific range of volumes until the firm needs to commit additional fixed operating or capital costs
See Table 14.2, p.475
Other Applications
1. Analyzing effects of other variables, e.g., price (prior slide) 2. Breakeven in terms of $ sales (p. 507) Sb = FC/ 1- (VC/P) 3. Breakeven in terms of EBT or EPS (add Int. to FC = fixed charges) 4. Target Volume (p. 507) Qt = (FC + Target Profit)/Contribution Margin/unit 5. Cash breakeven (p. 512-513) Qc = (FC Depr.)/Contri. Margin/unit Note: Useful for homework #7
EBIT-EPS Analysis
Use EBIT-EPS analysis for determining debt versus equity financing for individual projects But, should maintain target capital structure Steps
Develop economic/profit scenarios Begin with Earnings before Interest and Taxes (EBIT) and calculate Earnings Per Share (EPS) for both alternatives Best alternative has highest earnings per share Other considerations: flexibility, dilution of ownership/earnings, use of cash See Ex, p. 482
(EBIT Ie) (1 T) Dp = Ne
Equity financing
Equity Financing
Indifference Point
EBIT
Compute the indifference point between two financing plans. Estimate the probability that EBIT will exceed the indifference point (calc. z and use Table V). Examine the market evidence to see if the capital structure is too risky in relation to the firms level of
Business risk Industry norms for leverage and coverage ratios Recommendation of the firms investment bankers
5.
Warning!
Remember, financial leverage is a double-edged sword; it enhances expected returns but also increases risk
Even if EPS is higher with debt financing, high leverage could result in lower PE, and lower stock price (bottom p. 486) Lesson: the market will say whether borrowing is too risky
CB0 = cash at beginning of period, FCFR= free cash flows during recession, and CBR = cash balance during recession (you want it to be positive)
Summary
Operating Leverage--results from fixed operating
costs such that a change in sales revenue is magnified into a relatively large change in EBIT
such that a change in EBIT is magnified into a relatively large change in EPS
equity financing is preferred based on maximizing EPS structure during a recession when liquidity is important
Homework Problems
In this order: Ch 14: # 20, 14A: # 1 Assignment # 7: For Ford Automotive calculate the following:
1. Break-even units for EBIT 2. Break-even units for EBT 3. Graph TR and TC vs units showing #2 4. Units required to earn targeted EBT of $5 bils 5. Your realistic plan for #4 involving volume, cost and/or price changes (see Allegan Mfg.)