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Total Leverage
Total leverage is the use of any
fixed costs to magnify the effect
of changes in sales on the firms
net earnings.
The two components of total
leverage are operating and
financial leverage.
Categorizing two components
depend on where on the income
statement the fixed cost is found.
Measuring Total Leverage
Degree of Total Leverage:
Stylized form:
Note: DTL = DOLDFL.
Sales in Change %
Earnings Net in Change %
= DTL
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Capital Structure Theory
From WACC we know that the
most expensive sources of
capital are equity (common
stock and retained earnings).
From leverage analysis, we
know that adding debt adds
risk.
Adding risk adds cost to WACC.
Therefore adding debt will increase
its cost, and the cost of equity.
Capital Structure Theory
The goal of the financial manager
is to maximize shareholder
wealth:
What level of debt will maximize
the value of the firm to the
shareholder?
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k
NOPAT
k
T EBIT
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How Much Debt?
The optimal debt level depends
on:
Tax Benefit
Tax shield is a component of WACC
Any other tax shields?
Probability of Bankruptcy
Business Risk
Revenue Stability
Cost Stability
Level of Fixed Operating Costs
How Much Debt?
The optimal debt level depends
on:
Agency Costs
Risk of expropriation
Place monitoring costs on managers
These monitoring costs can reduce the
monitoring costs for equity investors as
well.
Other Considerations
Pecking Order Theory:
1) Use retained earnings
2) Issue more debt
3) Issue common equity
Signaling
Asymmetric information
Debt is generally seen as a
positive signal
Depends on rates and terms
The Optimal Capital Structure
Contrast EPS Method
The EPS-EBIT approach to capital
structure involves selecting the
capital structure that maximizes EPS
over the expected range of EBIT.
Using this approach, the emphasis is
on maximizing the owners returns
(EPS).
A major shortcoming of this
approach is the fact that earnings
are only one of the determinants of
shareholder wealth maximization.
This method does not explicitly
consider the impact of risk.
EPS-EBIT Approach
to Capital Structure (cont.)
EPS Shortcoming
Although EPS maximization is
generally good for the firms
shareholders, the basic shortcoming
of this method is that it does not
necessary maximize shareholder
wealth because it fails to consider
risk.
If shareholders did not require risk
premiums (additional return) as the
firm increased its use of debt, a
strategy focusing on EPS
maximization would work.
Unfortunately, this is not the case.
Choosing the Optimal
Capital Structure (cont.)
Choosing the Optimal
Capital Structure (cont.)
Choosing the Optimal
Capital Structure (cont.)