LEVERAGE AND THE CAPITAL

• DHANTY MEIDIANA HAPSARI

(201710160311043)
• SALMA AULIA AL-AMIN
(201710160311015)
• AULIA NANDA (201710160311007)
• HILAL RAFIF AULIA (201710160311036)
• DINDA WULANDARY (201710160311014)
LEVERAGE ?
 LEVERAGE
• Refers to the effect that fixed costs have on the returns that sharholders
earn, higher leverage generally results in higher but more volatile returns

• Firms have to pay these fixed costs whether business conditions are god or
bad. These fixed costs may be operating costs, such as the costs incurred by
purchasing and operating plant and equipment, or they may be financial
costs such as the fixed costs of making debt payment.

• Generally, leverage magnifies both returns and risks. A firm with more
leverage may earn higher returns on average than a firm with less leverage,
but the returns on the more leveraged firm will also be more volatile.

• Managers also influence leverage by choosing a specific capital structure,

which is the mix of long – term debt and equity maintained by a firm.

• Capital structure is the mix of long – term debt and equity maintained by
the firm.
 BREAKEVEN ANALYSIS
• firms use break even analysis, also called cost volume profit analysis,

a) To determine the level of operations necessary to cover all costs

b) To evaluate the profitability associated with various levels of sales.

• the firm's operating break even point is the level of sales necessary to
cover all operating costs. at that point, earnings before interest and taxes
(EBIT) equals $0.
 CHANGING COSTS AND THE OPERATING
BREAKEVEN POINT
• A firm’s operating breakeven point is sensitive to a number of variables:

a) The fixed operating cost (FC)

b) The sale price per unit (P)

c) The variable operating cost per unit (VC)

d) The sensitivity of the breakeven sales volume (Q)

• As might be expected, an increase in cost (FC or VC) tends to increase

the operating breakeven point, whereas an increase in the sale price per
unit (P) decreases the operating breakeven point.
 OPERATING LEVERAGE
• The use of fixed operating costs to magnify the effects of changes in sales
an the firm’s earnings before interest and taxes

Measuring the degree of operating leverage (DOL)

• Degree of Operating Leverage (DOL) is the numerical measure of the firm’s

operating leverage. It can be derived using the equation.

• Whenever the percentage change in EBIT resulting from a given percentage

change in sales is greater than the percentage change in sales, operating
leverage exists. In other words, as long as DOL is greater than “1”, there is
operating leverage.
Total Leverage

• We also can asesses the combined effect of operating and financial leverage
on the firm’s risk by using a framework similar to that used to developed
the individual concepts of leverage. This combined effect, or total leverage,
can be defined as the use of fixed costs, both operating and financial to
magnify the effects of changes in sales on the firm’s earnings per share.
Measuring the degree of Total Leverage (DTL)

• The degree of total leverage (DTL) is a numerical measure of the firm’s

total leverage

• Whenever the percentage change in EPS resulting from a given percentage

change in sales is greater than the percentage change in sales, total leverage
exists.
FINANCIAL LEVERAGE?
• Financial Leverage as the use of fixed financial cost to magnify the effect of change in
earnings before interest and taxes on the firm’s earnings per share. The two most
common fixed financial costs are :

a) Interest on debt

b) Preferred stock dividends.

Measuring the degree of financial leverage (DFL)

• The degree of financial leverage is a numerical measureof the firm's financial

leverage. computing it is much like computing the degree of operating leverage. one
approach for obtaining the DFL is :

• Whenever the percentage change in EPS resulting from a given percentage change in
EBIT is the percentage change in EBIT, financial leverage exists. In other word,
whenever DFL is greater than 1, there is financial leverage.
TOTAL LEVERAGE ?
• Total Leverage is the use of fixed costs, both operating and financial, to magnify the
effect of changes in sales on the firm's earnings per share.

Measuring the degree of total leverage (DTL)

• The degree of total leverage (DTL) is a numerical measure of the firm’s total
leverage. It can be computed much like operating and financial leverage are
compured. One approach for measuring DTL is :

• Wherenever the percentage change in EPS resulting from a given percentage change
in sales is greater than the percentage change in sales, total leverage exists. In other
words, as long as the DTL is greather than 1, there is total leverage.
RELATIONSHIP OF OPERATING,FINANCIAL, AND
TOTAL LEVERAGE
• Total leverage reflects the combined impact of operating and financial
leverage on the firm. High operating leverage and high financial leverage will
cause total leverage to be high. The opposite will also be true. The
relationship between the degree of Total leverage (DTL) and the degree of
operating leverage (DOL) and financial leverage (DFL) is given by
 THE FIRM’S CAPITAL STRUCTURE
• Capital structure is one the most complex areasof financial decision making because
of its interrelationship with other financial decision variables. Poor capital structure
decisions can result in a high cost of capital, thereby lowering the NPVs of projects
and making more of them unacceptable. Effective capital structure decision can
lower the cost of capital, resulting in higher NPVs and more acceptable projects and
thereby increasing the value of the firm.

Types Of Capital

• All the items on the right-hand side of the firm’s balance sheet, excluding current
liabilities, are sources of capital. The following simplified balance sheet illustrates the
basic breakdown of total capital into its two components, debt capital and
equitycapital :
a) Balance sheet

b) Current liabilities

c) Long-term debt

d) Debt capital

e) Assets

f) Stockholders’ equity

g) Preferred stock

h) Common stock equity

i) Common stock

j) Retained earnings

k) Equity Capital

l) Total capital
• The cost of debt is lower than the cost of other forms of financing. Lenders demand
relatively lower returns because they take the least risk of any contributors of long-
term capital. Lenders have a higher priority of claim against any earnings or assets
available for payment than can owners of preferred or common stock. The tax
deductibility of interest payments also lowers the debt cost to the firm substantially.

• Unlike debt capital, which the firm must eventually repay, equity capital remains
invested in the firm indefitrly; it has no maturity date. The two main sources of
equity capital are :

(1) preferred stock and

(2) common stock equity, which includes common stock and retained earnings.

• Common stock is typically the most expensive form equity, followed by retained
earnings and the preferred stock. Our concern here is the relationship between
debt and equity capital. In general, the more debt a firm uses, the greater will be the
firm’s financial leverage.
 EXTERNAL ASSESSMENT OF CAPITAL STRUCTURE
• We saw earlier that financial leverage results from the use of fixed-cost
financing. Such as debt and preferred stock, to magnify return and risk. The
amount of leverage in the firm’s capital structure can affect its value by
affecting return and risk. Those outside the firm can make a rough
assessment of capital structure by using measures found in the firm’s
financial statements.

• The level of debt (financial leverage) that is acceptable for one isdustry or
line of business can be highly risky in another, because different industries
and lines of business have different operating characteristics.
 CAPITAL STRUCTURE THEORY
• Research suggest that there is an optimal capital structure range.It is not yet
possible to provide financial managers with a precise methodology for determining a
firm's optimal capital structure. Nevertheless, financial theory does offer help in
understanding how a firm's capital structure affects the firm's value.

• theoritical optimal capital structure based on balancing the benefits and costs of
debt financing. The major benefit of debt financing is the tax shield, which allows
interest payments to be deducted in calculating taxable income. The cost of debt
financing results from :

(1) the increased prohbility of bankruptcy caused by debt obligations,

(2) the agency costs of the lender's constraining the firm's actions, and

(3) the cost associated with managers having more information about the firm's
prospects than do investors.
Tax Benefits

• Allowing firms to deduct interest payments on debt when calculating

taxable income reduces the amount of the firm's earnings paid in taxes,
thereby making more earnings available for bondholders and stock holders.
The deductibility of interest means the cost of debt, ri, to the firm is
subsidized by the government.

Probability Of Bankruptcy

• The chance that a firm will become bankrupt because of an inability to meet its
oblation as they come due depends largely on iys levels of both business risk and
financial risk. In general, the greater the firm's operating leverage-leverage the use of
fixed operating costs-the higher its business risk. Although operating leverage is an
important factor affecting business risk, two other factors-revenue stability and cost
stability-also affect it. Revenue stability reflects the relative variability of the firm's
sales revenues.
 ASYMMETRIC INFORMATION
• when two parties in an economic transaction have different information, we
say that there is asymmetric information, in the context of a description of
the capital structure. Asymmetric information only means that the form
manager has more information about form operations and luture prospects.

• Pecking order theory, suppose that managers of a company have high

profitable investment opportunities that require financing. This situation
makes increasing new equity very expensive, and sometimes managers can
decide to skip positive NPV investments to avoid having to sell equity to
investors at a discount. One solution to this problem is for managers to
maintain financial stacks, cash reserves from stored cartridges that they can
use to finance new investments.
• Signaling theory, in the old saying, "put your money where your mouth
is". The idea is that anyone can brag, but only those who are willing to put
the real dollar behind their claims must believe. how is this related to capital
structure decisions? for example, for example, that management has
information that the company's future prospects are very good. Managers
can make press releases trying to convince investors that the company's
future is bright, but investors will want clear evidence for claims.
furthermore, providing evidence must be expensive for the company;
otherwise, other companies with less bright prospects will only imitate the
company's actions with very good prospects.
 OPTIMAL CAPITAL STRUCTURE
• What, then, is the optimal structure, even if it exists (so far) only in theory?
to provide some insight into the answers, we will examine some basic
financial relationships. because the value of a company is equal to the
present value of its future cash flows, then the thr value of the company is
maximized when capital costs are minimized. in other words, the present
value of future cash flows is at the highest point when the discount rate
(capital cost) is at its lowest point. by using a modification of the simple
zero growth assessment model (see Equation 7.2 in Chapter 7), we can
reduce the value of the company, v, as :
Where,

• EBIT = income before interest and tax

• T = net income after tax, which is operating income after tax is available to holders of debt
and equity, EBIT x (1-T).

• Obviously, if we assume that NOPAT (and therefore EBIT) is constant, firm value,V, is
maximized by minimizing the cost of the weighted average capital, .

cost function

Figure 13. (a) plot three functions of costs - debt costs, equity costs, and weighted average cost
capital (WACC) - the financial leverage function as measured by the debt ratio (debt to total
assets). the cost of debt, remains low due to tax shielding, but slowly increases when leverage
increases, to compensate lenders to increase risk. equity costs, , are above the cost of debt. it
increases when financial leverage increases, but generally increases faster to the cost of debt.
Cost equity increases because shareholders need a higher return because leverage increases
to offset a higher level of financial risk.
• Capital weighted average cost, , results from the weighted average corporate debt
and uqity capital costs. at zero debt ratio, the company is 100 percent equity funded.
because debt is replaced for equity and when the debt ratio increases, WAAC
decreases because the cost of post-tax debt is lower than the cost of equity ( <).
within this range, the tax benefit of additional debt is greater than the cost of
borrowing more. However, because the debt ratio continues to increase, the
increase in debt and the cost of equity ultimately causes the WACC to increase, as
can be seen after point M in figure 13.5 (a). in other words, bankruptcy costs, agency
costs, and other costs associated with higher levels of debt ultimately exceed the
additional tax benefits that the company can generate by borrowing more. this
behavior results in a function of the average U-shaped capital cost, or plate-shaped,
weighted average.
 GRAPHIAL DESCRIPTION OF OPTIMAL STRUCTURE
• Because the maximization of value, V, is reached when the overall capital cost, , is minimal (see
Equation 13.11), the optimal capital structure is where the weighted capital cost, , is minimized.
In figure 13.5 (a), point M represents the minimum weighted capital cost, the optimal financial
leverage point and hence the optimal capital structure for the company. Figure 13.5 (b) is a
graph of firm value generated from substitution in figure 13.5 (a) for various core financial
leverage levels of the zero growth valuation model in equation 13.11. As shown in figure 13.5
(b), in the optimal capital structure, point M, the company value is maximized at .

• Simply stated, minimizing the weighted average cost of capital allows management to carry out
a large number of profitable projects, thereby further increasing the value of the company.
However, as a practical problem, there is no way to wrap the optimal capital structure shown
in figure 13.5. because it is not possible to know or stick to the optimal optimal capital
structure, companies generally try to operate in a range that places them near what they
believe is the optimal capital structure. in other wordds, companies usually manage towards
the target capital structure.
APPROACH TO EBIT-EPS WITH CAPITAL STRUCTURE
• It must be clear from the previous chapter that the goal of a financial manager is to maximize
the owner's wealth, that is, the company's stock price. One variable that is widely followed
influences the company's stock price is its income, which represents profits earned on behalf
of the owner. Although focusing on income ignores risk (other key variables that affect a
company's stock price), earnings per share (ESP) can easily be used to analyze alternative
capital structures. The EBIT-ESP approach to capital structure involves choosing a capital
structure that maximizes (ESP) because it issues anger before earnings and taxes (EBIT).

PRESENTING THE GRAPHIC FINANCING PLAN

• to analyze the effect of a company's capital structure on owner returns, we consider the
relationship between pre-interest income and tax (EBIT) and per-share income (ESP). in other
words, we want to see how EBIT changes cause changes in ESP under different capital
structures. That is, the company's basic operational risks remain constant, and only financial
risk varies when the capital structure changes. ESP is used to measure owner returns, which
are expected to be closely related to stock prices.
DATA NEEDED

• To draw a graph that illustrates how changes in EBIT cause changes in ESP, we only
need to find two coordinates and plot a straight line between them. In our graph, we
will plot EBIT on the horizontal axis and ESP on the vertical axis. The following
example illustrates the approach to building graphics.

PUTING DATA

• Cookery company data can be plotted on a set of EBIT-EPS axes as shown in figure
13.6. This number shows the expected EPS level for each EBIT level. For EBIT levels
below the x-axis cut, yield loss (negative EPS). Every x-axis intercept is a financial
break-even point, the EBIT level is required to only cover all fixed financial cost (EPS
= $ 0).
COMPARING ALTERNATIVE CAPITAL
STRUCTURES ?
 CONSIDERING RISK IN EBIT-EPS ANALYSIS
• Graphically, the risk of each capital structure can be viewed in light of two measures :

1) The financial breakeven point (EBIT – axis intercept)

2) The degree of financial leverage reflected in the slope of the capital structure line : The
higher the financial breakeven point and the steeper the slope of the capital structure line, the
greater the financial risk.

Basic shortcoming of EBIT-EPS Analysis

• The most important point to recognize when using EBIT – EPS analysis is that this
technique tends to concentrate on maximizing earnings rather than maximizing owner
wealth as reflected in the firm’s stock price.

• To select the best capital structure, firms must integrate both return (EPS) and risk (via the
required return, Rs) into a valuation framework consistent with the capital structure theory
presented earlier.
 CHOOSING THE OPTIMAL CAPITAL STRUCTURE
• Linkage

To determine the firm’s value under alternative capital structures, the firm must find
the level of return that it must earn to compensate owners for the risk being
incurred.

• Estimating Value

The value of the firm associated with alternative capital structure can be estimated by using
one of the standard valuation models. If,for simplicity, we assume that all earnings are paid out
devidends, we can use a zero-growth valuation model. The model, orginally stated is restated
here with EPS sibtituted for dividends.

• Maximize value versus maximizing EPS

Throughtout this text, we have specified the goal of the financial manager as maximizing
owner wealth, not profit. Although, some relationship exist between expected profit and
value, there is no reason to believe that profit-maximizing strategies necessarily result in
wealth maximizing. It is therefore the wealth of the owners as reflected in the estimated
share value that should serve as the criterion for selecting the best capital structure