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Various Tools Of Analysis Assist Managers

Making Capital Structure decision


Maximization of Shareholder Wealth

In Finance, leverage is defined as a firms use of assets and liabilities having fixed costs in an attempt to increase potential returns to stockholders.

Important

components of a firms business risk and financial risk by a firm in the hope of earning returns in excess of the fixed costs of its assets and liabilities, thereby increasing the returns to common stockholders

Used

Over the short run, certain operating costs within a firm vary directly with the level of sales whereas other costs remain constant, regardless of changes in the sales level.

Costs that move in close relationship to changes in sales Tied to the no. of units produced and sold Raw materials, Direct Labor costs, Sales Commissions

Primarily related to the passage of time Independent of sales or output levels Depreciation on PPE; Rent; Property Taxes

Costs that increase in a stepwise manner as output increase Income Taxes, Utility Costs

FULCRUM Multiplier Effect resulting from the firms use of fixed operating costs

DOL @ X = % change in EBIT % change in sales EBIT EBIT Sales Sales

DOL @ X =

(1) Sales Variable Costs (60% of Sales) Fixed Operating Costs Total Operating Costs EBIT Interest Payments Earning Before Taxes $5,000,000 3,000,000 1,000,000 4,000,000 1,000,000 250,000 750,000

(2) $ 5,500,000 3,300,000 1,000,000 4,300,000 1,200,000 250,000 950,000

Income Taxes ( Variable, 40%)


Earnings After Tax Preferred Dividends
Earnings to Common shareholders Earnings/ SH 100,000 shares

300,000
450,000 150,000 300,000

380,000
570,000 150,000 420,000

$3

$4.2

DOL @ $5,000,000 = 20% / 10% = 2.0


2.0 signifies the proportion of change between EBIT & Sales.

Each 1% change in sales from the base sales level of $5 million results in a 2% change in EBIT in the same direction as the sales change.

DOL @ X = Sales Variable Costs EBIT

(1) Sales Variable Costs (60% of Sales) Fixed Operating Costs Total Operating Costs EBIT Interest Payments Earning Before Taxes $5,000,000 3,000,000 1,000,000 4,000,000 1,000,000 250,000 750,000

(2) $ 5,500,000 3,300,000 1,000,000 4,300,000 1,200,000 250,000 950,000

Income Taxes ( Variable, 40%)


Earnings After Tax Preferred Dividends
Earnings to Common shareholders Earnings/ SH 100,000 shares

300,000
450,000 150,000 300,000

380,000
570,000 150,000 420,000

$3

$4.2

DOL is the measurement of the relationship of a companys contribution margin to income from operations. Fixed Operating Cost

DOL

DOL @ X = % change in EPS % change in EBIT EPS EPS EBIT EBIT

DOL @ X =

(1) Sales Variable Costs (60% of Sales) Fixed Operating Costs Total Operating Costs EBIT Interest Payments Earning Before Taxes Income Taxes ( Variable, 40%) Earnings After Tax Preferred Dividends
Earnings to Common shareholders Earnings/ SH 100,000 shares

(2) $ 5,500,000 3,300,000 1,000,000 4,300,000 1,200,000 250,000 950,000 380,000 570,000 150,000 420,000 $4.2

$5,000,000 3,000,000 1,000,000 4,000,000 1,000,000 250,000 750,000 300,000 450,000 150,000 300,000 $3

DFL @ $1,000,000 = 40% / 20% = 2.0 A DFL of 2.0 means that each 1% change in EBIT from a base of $1 million results in a 2% change in EPS in the same direction as the EBIT change.

DFL @ X =

EBIT EBIT - INT {DIV / (1-TR)}

(1) Sales Variable Costs (60% of Sales)


Fixed Operating Costs Total Operating Costs

(2) $ 5,500,000 3,300,000 1,000,000 4,300,000 1,200,000 250,000 950,000


=

$5,000,000 3,000,000 1,000,000 4,000,000 1,000,000 250,000 750,000 300,000 450,000 150,000 300,000 $3

EBIT - INT {DIV / (1-TR)}

EBIT

EBIT Interest Payments Earning Before Taxes


Income Taxes ( Variable, 40%)

= $1,000,000 $1M - $250,000 ($150, 000/ .60)


= $ 1,000,000 $1M - $250,000 - $250,000

=
380,000 570,000 150,000 420,000 $4.2

$ 1,000,000 $500,000

Earnings After Tax Preferred Dividends


Earnings to Common shareholders Earnings/ SH 100,000 shares

= 2.0

High Financial Leverage High Fixed Capital Costs

Decline of the Market Value of Firm


Cost of Capital to Rise