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Ch 16- Operating and Financial Leverage
 

Ch 16- Operating and Financial Leverage

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Financial Management by Van Horne

Financial Management by Van Horne
Ch 16- Operating and Financial Leverage

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    Ch 16- Operating and Financial Leverage Ch 16- Operating and Financial Leverage Presentation Transcript

    • 6-1Chapter 16Chapter 16Operating andOperating andFinancial LeverageFinancial Leverage© 2001 Prentice-Hall, Inc.Fundamentals of Financial Management, 11/eCreated by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI
    • 6-2Operating andOperating andFinancial LeverageFinancial LeverageOperating LeverageFinancial LeverageTotal LeverageCash-Flow Ability to Service DebtOther Methods of AnalysisCombination of Methods
    • 6-3Operating LeverageOperating LeverageOne potential “effect” caused by thepresence of operating leverage isthat a change in the volume of salesresults in a “more than proportional”change in operating profit (or loss).Operating LeverageOperating Leverage -- The use of-- The use offixed operating costs by the firm.fixed operating costs by the firm.
    • 6-4Impact of OperatingImpact of OperatingLeverage on ProfitsLeverage on ProfitsFirm F Firm V Firm 2FFirm F Firm V Firm 2FSales $10 $11 $19.5Operating CostsFixed 7 2 14Variable 2 7 3Operating Profit $$ 11 $ 2$ 2 $ 2.5$ 2.5FC/total costs .78 .22 .82FC/sales .70 .18 .72(in thousands)(in thousands)
    • 6-5Impact of OperatingImpact of OperatingLeverage on ProfitsLeverage on ProfitsNow, subject each firm to a 50%50%increase in salesincrease in sales for next year.Which firm do you think will be more“sensitive”“sensitive” to the change in sales (i.e.,show the largest percentage change inoperating profit, EBIT)?[ ] Firm FFirm F; [ ] Firm VFirm V; [ ] Firm 2FFirm 2F.
    • 6-6Impact of OperatingImpact of OperatingLeverage on ProfitsLeverage on ProfitsFirm F Firm V Firm 2FFirm F Firm V Firm 2FSales $15 $16.5 $29.25Operating CostsFixed 7 2 14Variable 3 10.5 4.5Operating Profit $$ 55 $ 4$ 4 $10.75$10.75PercentagePercentageChange in EBITChange in EBIT* 400% 100% 330%400% 100% 330%(in thousands)(in thousands)* (EBITt - EBIT t-1) / EBIT t-1
    • 6-7Impact of OperatingImpact of OperatingLeverage on ProfitsLeverage on ProfitsFirm FFirm F is the most “sensitive” firmis the most “sensitive” firm -- for it, a 50%increase in sales leads to a 400% increase in400% increase inEBITEBIT.Our example reveals that it is a mistake toassume that the firm with the largest absolute orrelative amount of fixed costs automaticallyshows the most dramatic effects of operatingleverage.Later, we will come up with an easy way to spotthe firm that is most sensitive to the presence ofoperating leverage.
    • 6-8Break-Even AnalysisBreak-Even AnalysisWhen studying operating leverage,“profits” refers to operating profitsbefore taxes (i.e., EBIT) and excludesdebt interest and dividend payments.Break-Even AnalysisBreak-Even Analysis -- A technique forstudying the relationship among fixedcosts, variable costs, profitsprofits, and salesvolume.
    • 6-9Break-Even ChartBreak-Even ChartQUANTITY PRODUCED AND SOLDQUANTITY PRODUCED AND SOLD0 1,000 2,000 3,000 4,0004,000 5,000 6,000 7,000Total RevenuesTotal RevenuesProfitsProfitsFixed CostsFixed CostsVariable CostsVariable CostsLossesLossesREVENUESANDCOSTSREVENUESANDCOSTS($thousands)($thousands)17517525010050Total CostsTotal Costs
    • 6-10Break-EvenBreak-Even(Quantity) Point(Quantity) PointHow to find the quantity break-even point:EBIT = PP(QQ) - VV(QQ) - FCFCEBIT = QQ(PP - VV) - FCFCP = Price per unitP = Price per unit V = Variable costs per unitV = Variable costs per unitFC = Fixed costsFC = Fixed costs Q = Quantity (units)Q = Quantity (units)produced and soldproduced and soldBreak-Even PointBreak-Even Point -- The sales volume required-- The sales volume requiredso that total revenues and total costs areso that total revenues and total costs areequal; may be in units or in sales dollars.equal; may be in units or in sales dollars.
    • 6-11Break-EvenBreak-Even(Quantity) Point(Quantity) PointBreakeven occurs when EBIT = 0QQ (PP - VV) - FCFC = EBITQQBEBE (PP - VV) - FCFC = 0QQBEBE (PP - VV) = FCFCQQBEBE = FCFC / (PP - VV)
    • 6-12Break-Even (Sales) PointBreak-Even (Sales) PointHow to find the sales break-even point:SSBEBE =FCFC + (VCVCBEBE)SSBEBE =FCFC + (QQBEBE )(VV)orSSBEBE**=FCFC / [1 - (VCVC / S) ]* Refer to text for derivation of the formula
    • 6-13Break-EvenBreak-EvenPoint ExamplePoint ExampleBasket Wonders (BW) wants todetermine both the quantity and salesquantity and salesbreak-even pointsbreak-even points when:Fixed costsFixed costs are $100,000$100,000Baskets are sold for $43.75$43.75 eacheachVariable costs are $18.75 per basket$18.75 per basket
    • 6-14Break-Even Point (s)Break-Even Point (s)Breakeven occurs when:QQBEBE = FCFC / (PP - VV)QQBEBE = $100,000$100,000 / ($43.75$43.75 - $18.75$18.75)QQBEBE = 4,000 Units4,000 UnitsSSBEBE =(QQBEBE )(VV) + FCFCSSBEBE =(4,0004,000 )($18.75$18.75) + $100,000$100,000SSBEBE = $175,000$175,000
    • 6-15Break-Even ChartBreak-Even ChartQUANTITY PRODUCED AND SOLDQUANTITY PRODUCED AND SOLD0 1,000 2,000 3,000 4,0004,000 5,000 6,000 7,000Total RevenuesTotal RevenuesProfitsProfitsFixed CostsFixed CostsVariable CostsVariable CostsLossesLossesREVENUESANDCOSTSREVENUESANDCOSTS($thousands)($thousands)17517525010050Total CostsTotal Costs
    • 6-16Degree of OperatingDegree of OperatingLeverage (DOL)Leverage (DOL)DOLDOL at Qunits ofoutput(or sales)Degree of Operating LeverageDegree of Operating Leverage -- Thepercentage change in a firm’s operatingprofit (EBIT) resulting from a 1 percentchange in output (sales).=Percentage change inoperating profit (EBIT)Percentage change inoutput (or sales)
    • 6-17Computing the DOLComputing the DOLDOLDOLQ unitsQ unitsCalculating the DOL for a single productCalculating the DOL for a single productor a single-product firm.or a single-product firm.=QQ (PP - VV)QQ (PP - VV) - FCFC= QQQQ - QQBEBE
    • 6-18Computing the DOLComputing the DOLDOLDOLS dollars of salesS dollars of salesCalculating the DOL for aCalculating the DOL for amultiproduct firm.multiproduct firm.=SS - VCVCSS - VCVC - FCFC=EBIT + FCFCEBIT
    • 6-19Break-EvenBreak-EvenPoint ExamplePoint ExampleLisa Miller wants to determine the degreedegreeof operating leverageof operating leverage at sales levels ofsales levels of6,000 and 8,000 units6,000 and 8,000 units. As we did earlier,we will assume that:Fixed costsFixed costs are $100,000$100,000Baskets are sold for $43.75$43.75 eacheachVariable costs are $18.75 per basket$18.75 per basket
    • 6-20Computing BW’s DOLComputing BW’s DOLDOLDOL6,000 units6,000 unitsComputation based on the previouslyComputation based on the previouslycalculated break-even point of 4,000 unitscalculated break-even point of 4,000 units=6,0006,0006,0006,000 - 4,0004,000== 33DOLDOL8,000 units8,000 units8,0008,0008,0008,000 - 4,0004,000= 22
    • 6-21Interpretation of the DOLInterpretation of the DOLA 1% increase in sales above the 8,000A 1% increase in sales above the 8,000unit level increases EBIT by 2%unit level increases EBIT by 2%because of the existing operatingbecause of the existing operatingleverage of the firm.leverage of the firm.=DOLDOL8,000 units8,000 units8,0008,0008,0008,000 - 4,0004,000= 22
    • 6-22Interpretation of the DOLInterpretation of the DOL2,0002,000 4,0004,000 6,000 8,0006,000 8,0001122334455QUANTITY PRODUCED AND SOLDQUANTITY PRODUCED AND SOLD00-1-1-2-2-3-3-4-4-5-5DEGREEOFOPERATINGDEGREEOFOPERATINGLEVERAGE(DOL)LEVERAGE(DOL)QQBEBE
    • 6-23Interpretation of the DOLInterpretation of the DOLDOL is a quantitative measure of the “sensitivity”of a firm’s operating profit to a change in thefirm’s sales.The closer that a firm operates to its break-evenpoint, the higher is the absolute value of its DOL.When comparing firms, the firm with the highestDOL is the firm that will be most “sensitive” to achange in sales.Key Conclusions to be Drawn from SlideKey Conclusions to be Drawn from Slide16-22 and our Discussion of DOL16-22 and our Discussion of DOL
    • 6-24DOL and Business RiskDOL and Business RiskDOL is only one componentone component of business riskand becomes “active” only in the presenceonly in the presenceof sales and production cost variabilityof sales and production cost variability.DOL magnifiesmagnifies the variability of operatingprofits and, hence, business risk.Business RiskBusiness Risk -- The inherent uncertainty-- The inherent uncertaintyin the physical operations of the firm. Itsin the physical operations of the firm. Itsimpact is shown in the variability of theimpact is shown in the variability of thefirm’s operating income (EBIT).firm’s operating income (EBIT).
    • 6-25Application of DOL forApplication of DOL forOur Three Firm ExampleOur Three Firm ExampleUse the data in Slide 16-4 and theUse the data in Slide 16-4 and thefollowing formula forfollowing formula for Firm FFirm F::DOLDOL = [(= [(EBITEBIT ++ FCFC)/)/EBITEBIT]]=DOLDOL$10,000 sales$10,000 sales1,0001,000 ++ 7,0007,0001,0001,000= 8.08.0
    • 6-26Application of DOL forApplication of DOL forOur Three Firm ExampleOur Three Firm ExampleUse the data in Slide 16-4 and theUse the data in Slide 16-4 and thefollowing formula forfollowing formula for Firm VFirm V::DOLDOL = [(= [(EBITEBIT ++ FCFC)/)/EBITEBIT]]=DOLDOL$11,000 sales$11,000 sales2,0002,000 ++ 2,0002,0002,0002,000= 2.02.0
    • 6-27Application of DOL forApplication of DOL forOur Three-Firm ExampleOur Three-Firm ExampleUse the data in Slide 16-4 and theUse the data in Slide 16-4 and thefollowing formula forfollowing formula for Firm 2FFirm 2F::DOLDOL = [(= [(EBITEBIT ++ FCFC)/)/EBITEBIT]]=DOLDOL$19,500 sales$19,500 sales2,5002,500 ++ 14,00014,0002,5002,500= 6.66.6
    • 6-28Application of DOL forApplication of DOL forOur Three-Firm ExampleOur Three-Firm ExampleThe ranked results indicate that the firm mostThe ranked results indicate that the firm mostsensitive to the presence of operating leveragesensitive to the presence of operating leverageisis Firm FFirm F.Firm FFirm F DOLDOL == 8.08.0Firm VFirm V DOLDOL == 6.66.6Firm 2FFirm 2F DOLDOL == 2.02.0Firm FFirm F will expect awill expect a 400% increase in profit400% increase in profit from afrom a 50%50%increase in salesincrease in sales (see Slide 16-6 results).(see Slide 16-6 results).
    • 6-29Financial LeverageFinancial LeverageFinancial leverage is acquired bychoice.Used as a means of increasing thereturn to common shareholders.Financial LeverageFinancial Leverage -- The use of-- The use offixed financing costs by the firm.fixed financing costs by the firm.The British expression isThe British expression is gearinggearing..
    • 6-30EBIT-EPS Break-Even,EBIT-EPS Break-Even,or Indifference, Analysisor Indifference, AnalysisCalculate EPSEPS for a given level of EBITEBIT at agiven financing structure.EBIT-EPS Break-Even AnalysisEBIT-EPS Break-Even Analysis -- Analysis-- Analysisof the effect of financing alternatives onof the effect of financing alternatives onearnings per share. The break-even point isearnings per share. The break-even point isthe EBIT level where EPS is the same forthe EBIT level where EPS is the same fortwo (or more) alternatives.two (or more) alternatives.(EBITEBIT - I) (1 - t) - Pref. Div.# of Common SharesEPSEPS =
    • 6-31EBIT-EPS ChartEBIT-EPS ChartCurrent common equity shares = 50,000Current common equity shares = 50,000$1 million in new financing of either:$1 million in new financing of either:All C.S. sold at $20/share (50,000 shares)All debt with a coupon rate of 10%All P.S. with a dividend rate of 9%Expected EBIT = $500,000Expected EBIT = $500,000Income tax rate is 30%Income tax rate is 30%Basket WondersBasket Wonders has $2 million in LT financinghas $2 million in LT financing(100% common stock equity).(100% common stock equity).
    • 6-32EBIT-EPS Calculation withEBIT-EPS Calculation withNew Equity FinancingNew Equity FinancingEBITEBIT $500,000$500,000 $150,000$150,000*Interest 0 0EBT $500,000 $150,000Taxes (30% x EBT) 150,000 45,000EAT $350,000 $105,000Preferred Dividends 0 0EACSEACS $350,000$350,000 $105,000$105,000# of Shares 100,000 100,000EPSEPS $3.50$3.50 $1.05$1.05Common Stock Equity AlternativeCommon Stock Equity Alternative* A second analysis using $150,000 EBIT rather than the expected EBIT.
    • 6-33EBIT-EPS ChartEBIT-EPS Chart0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700EBIT ($ thousands)EBIT ($ thousands)EarningsperShare($)EarningsperShare($)00112233445566CommonCommon
    • 6-34EBIT-EPS Calculation withEBIT-EPS Calculation withNew Debt FinancingNew Debt FinancingEBITEBIT $500,000$500,000 $150,000$150,000*Interest 100,000 100,000EBT $400,000 $ 50,000Taxes (30% x EBT) 120,000 15,000EAT $280,000 $ 35,000Preferred Dividends 0 0EACSEACS $280,000$280,000 $ 35,000$ 35,000# of Shares 50,000 50,000EPSEPS $5.60$5.60 $0.70$0.70Long-term Debt AlternativeLong-term Debt Alternative* A second analysis using $150,000 EBIT rather than the expected EBIT.
    • 6-35EBIT-EPS ChartEBIT-EPS Chart0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700EBIT ($ thousands)EBIT ($ thousands)EarningsperShare($)EarningsperShare($)00112233445566CommonCommonDebtDebtIndifference pointbetween debtdebt andcommon stockcommon stockfinancing
    • 6-36EBIT-EPS Calculation withEBIT-EPS Calculation withNew Preferred FinancingNew Preferred FinancingEBITEBIT $500,000$500,000 $150,000$150,000*Interest 0 0EBT $500,000 $150,000Taxes (30% x EBT) 150,000 45,000EAT $350,000 $105,000Preferred Dividends 90,000 90,000EACSEACS $260,000$260,000 $ 15,000$ 15,000# of Shares 50,000 50,000EPSEPS $5.20$5.20 $0.30$0.30Preferred Stock AlternativePreferred Stock Alternative* A second analysis using $150,000 EBIT rather than the expected EBIT.
    • 6-370 100 200 300 400 500 600 7000 100 200 300 400 500 600 700EBIT-EPS ChartEBIT-EPS ChartEBIT ($ thousands)EBIT ($ thousands)EarningsperShare($)EarningsperShare($)00112233445566CommonCommonDebtDebtIndifference pointbetween preferredpreferredstockstock and commoncommonstockstock financingPreferredPreferred
    • 6-38What About Risk?What About Risk?0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700EBIT ($ thousands)EBIT ($ thousands)EarningsperShare($)EarningsperShare($)00112233445566CommonCommonDebtDebtLower riskLower risk. Only a smallprobability that EPS willbe less if the debtalternative is chosen.ProbabilityofOccurrenceProbabilityofOccurrence(fortheprobabilitydistribution)(fortheprobabilitydistribution)
    • 6-39What About Risk?What About Risk?0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700EBIT ($ thousands)EBIT ($ thousands)EarningsperShare($)EarningsperShare($)00112233445566CommonCommonDebtDebtHigher riskHigher risk. A much largerprobability that EPS willbe less if the debtalternative is chosen.ProbabilityofOccurrenceProbabilityofOccurrence(fortheprobabilitydistribution)(fortheprobabilitydistribution)
    • 6-40Degree of FinancialDegree of FinancialLeverage (DFL)Leverage (DFL)DFLDFL atEBIT ofX dollarsDegree of Financial LeverageDegree of Financial Leverage -- Thepercentage change in a firm’s earningsper share (EPS) resulting from a 1percent change in operating profit.=Percentage change inearnings per share (EPS)Percentage change inoperating profit (EBIT)
    • 6-41Computing the DFLComputing the DFLDFLDFLEBIT of $XCalculating the DFLCalculating the DFL=EBITEBITEBITEBIT - II - [ PDPD / (1 - tt) ]EBITEBIT = Earnings before interest and taxes= Earnings before interest and taxesII = Interest= InterestPDPD = Preferred dividends= Preferred dividendstt = Corporate tax rate= Corporate tax rate
    • 6-42What is the DFL for EachWhat is the DFL for Eachof the Financing Choices?of the Financing Choices?DFLDFL$500,000$500,000Calculating the DFL forCalculating the DFL for NEWNEW equityequity* alternativealternative=$500,000$500,000$500,000$500,000 - 00 - [00 / (1 - 00)]* The calculation is based on the expected EBIT= 1.001.00
    • 6-43What is the DFL for EachWhat is the DFL for Eachof the Financing Choices?of the Financing Choices?DFLDFL$500,000$500,000Calculating the DFL forCalculating the DFL for NEWNEW debtdebt * alternativealternative=$500,000$500,000{{ $500,000$500,000 - 100,000100,000- [00 / (1 - 00)] }* The calculation is based on the expected EBIT= $500,000$500,000 / $400,0001.251.25=
    • 6-44What is the DFL for EachWhat is the DFL for Eachof the Financing Choices?of the Financing Choices?DFLDFL$500,000$500,000Calculating the DFL forCalculating the DFL for NEWNEW preferredpreferred * alternativealternative=$500,000$500,000{{ $500,000$500,000 - 00- [90,00090,000 / (1 - .30.30)] }* The calculation is based on the expected EBIT= $500,000$500,000 / $400,0001.351.35=
    • 6-45Variability of EPSVariability of EPSPreferred stockPreferred stock financing will lead tothe greatest variability in earnings pershare based on the DFL.This is due to the tax deductibility ofinterest on debt financing.DFLDFLEquityEquity = 1.00= 1.00DFLDFLDebtDebt = 1.25= 1.25DFLDFLPreferredPreferred == 1.351.35Which financingmethod will havethe greatest relativegreatest relativevariability in EPS?variability in EPS?
    • 6-46Financial RiskFinancial RiskDebt increases the probability of cashinsolvency over an all-equity-financed firm. Forexample, our example firm must have EBIT of atleast $100,000 to cover the interest payment.Debt also increased the variability in EPS as theDFL increased from 1.00 to 1.25.Financial RiskFinancial Risk -- The added variability in-- The added variability inearnings per share (EPS) -- plus the risk ofearnings per share (EPS) -- plus the risk ofpossible insolvency -- that is induced by thepossible insolvency -- that is induced by theuse of financial leverage.use of financial leverage.
    • 6-47Total Firm RiskTotal Firm RiskCVCVEPSEPS is a measure of relative total firm risktotal firm riskCVCVEBITEBIT is a measure of relative business riskbusiness riskThe difference, CVCVEPSEPS - CV- CVEBITEBIT, is a measure ofrelative financial riskfinancial riskTotal Firm RiskTotal Firm Risk -- The variability in earnings per-- The variability in earnings pershare (EPS). It is the sum of business plusshare (EPS). It is the sum of business plusfinancial risk.financial risk.Total firm riskTotal firm risk = business riskbusiness risk + financial riskfinancial risk
    • 6-48Degree of TotalDegree of TotalLeverage (DTL)Leverage (DTL)DTLDTL at Q units(or S dollars)of output (orsales)Degree of Total LeverageDegree of Total Leverage -- Thepercentage change in a firm’s earningsper share (EPS) resulting from a 1percent change in output (sales).=Percentage change inearnings per share (EPS)Percentage change inoutput (or sales)
    • 6-49Computing the DTLComputing the DTLDTLDTLS dollarsof salesDTLDTL Q units (or S dollars)Q units (or S dollars) = ( DOLDOL Q units (or S dollars)Q units (or S dollars) )x ( DFLDFL EBIT of X dollarsEBIT of X dollars )=EBITEBIT + FCEBITEBIT - II - [ PDPD / (1 - tt) ]DTLDTL Q unitsQQ (PP -- VV)QQ (PP -- VV) - FC - II - [ PDPD / (1 - tt) ]=
    • 6-50DTL ExampleDTL ExampleLisa Miller wants to determine theDegree of Total LeverageDegree of Total Leverage atEBIT=$500,000.EBIT=$500,000. As we did earlier, wewill assume that:Fixed costsFixed costs are $100,000$100,000Baskets are sold for $43.75$43.75 eacheachVariable costs are $18.75 per basket$18.75 per basket
    • 6-51Computing the DTLComputing the DTLfor All-Equity Financingfor All-Equity FinancingDTLDTLS dollarsof sales=$500,000$500,000 + $100,000$500,000$500,000 - 00 - [ 00 / (1 - .3.3) ]DTLDTLS dollarsS dollars = (DOLDOL S dollarsS dollars) x (DFLDFLEBIT of $SEBIT of $S )DTLDTLS dollarsS dollars = (1.21.2 ) x ( 1.01.0* ) = 1.201.20= 1.201.20*Note: No financial leverage.
    • 6-52Computing the DTLComputing the DTLfor Debt Financingfor Debt FinancingDTLDTLS dollarsof sales=$500,000$500,000 + $100,000{ $500,000$500,000 - $100,000$100,000- [ 00 / (1 - .3.3) ] }DTLDTLS dollarsS dollars = (DOLDOL S dollarsS dollars) x (DFLDFLEBIT of $SEBIT of $S )DTLDTLS dollarsS dollars = (1.21.2 ) x ( 1.251.25* ) = 1.501.50= 1.501.50*Note: Calculated on Slide 43.
    • 6-53Risk versus ReturnRisk versus ReturnCompare the expected EPS to the DTL forthe common stock equity financingapproach to the debt financing approach.FinancingFinancing E(EPS)E(EPS) DTLDTLEquityEquity $3.50$3.50 1.201.20DebtDebt $5.60$5.60 1.501.50Greater expected return (higher EPS) comes atGreater expected return (higher EPS) comes atthe expense of greater potential risk (higher DTL)!the expense of greater potential risk (higher DTL)!
    • 6-54What is an AppropriateWhat is an AppropriateAmount of Financial Leverage?Amount of Financial Leverage?Firms must first analyze their expected futureexpected futurecash flows.cash flows.The greatergreater and more stablemore stable the expected futurecash flows, the greater the debt capacity.the greater the debt capacity.Fixed charges includeFixed charges include: debt principal andinterest payments, lease payments, andpreferred stock dividends.Debt CapacityDebt Capacity -- The maximum amount of debt-- The maximum amount of debt(and other fixed-charge financing) that a firm(and other fixed-charge financing) that a firmcan adequately service.can adequately service.
    • 6-55Coverage RatiosCoverage RatiosInterest CoverageInterest CoverageEBITEBITInterest expensesInterest expensesIndicates a firm’sability to coverinterest charges.Income StatementRatiosCoverage RatiosA ratio value equal to 1indicates that earningsare just sufficient tocover interest charges.
    • 6-56Coverage RatiosCoverage RatiosDebt-service CoverageDebt-service CoverageEBITEBIT{ Interest expensesInterest expenses +[Principal payments / (1-t)Principal payments / (1-t) ] }Indicates a firm’sability to coverinterest expenses andprincipal payments.Income StatementRatiosCoverage RatiosAllows us to examine theability of the firm to meetall of its debt payments.Failure to make principalpayments is also default.
    • 6-57Coverage ExampleCoverage ExampleMake an examination of the coveragecoverageratiosratios for Basket Wonders whenEBIT=$500,000.EBIT=$500,000. Compare the equityand the debt financing alternatives.Assume thatAssume that:Interest expensesInterest expenses remain at $100,000$100,000Principal payments of $100,000Principal payments of $100,000 aremade yearly for 10 years
    • 6-58Coverage ExampleCoverage ExampleCompare the interest coverage and debtburden ratios for equity and debt financing.InterestInterest Debt-serviceDebt-serviceFinancingFinancing CoverageCoverage CoverageCoverageEquityEquity InfiniteInfinite InfiniteInfiniteDebtDebt 5.005.00 2.502.50The firm actually has greater risk than the interestThe firm actually has greater risk than the interestcoverage ratio initially suggests.coverage ratio initially suggests.
    • 6-59Coverage ExampleCoverage Example-250 0 250 500 750 1,000 1,250-250 0 250 500 750 1,000 1,250EBIT ($ thousands)EBIT ($ thousands)Firm B has a muchsmaller probabilityof failing to meet itsobligations than Firm A.Firm BFirm BFirm AFirm ADebt-service burdenDebt-service burden= $200,000= $200,000PROBABILITYOFOCCURRENCEPROBABILITYOFOCCURRENCE
    • 6-60Summary of the CoverageSummary of the CoverageRatio DiscussionRatio DiscussionA single ratio value cannot be interpretedidentically for all firms as some firms havegreater debt capacity.Annual financial lease payments should beadded to both the numerator anddenominator of the debt-service coverageratio as financial leases are similar to debt.The debt-service coverage ratio accountsfor required annual principal payments.
    • 6-61Other Methods of AnalysisOther Methods of AnalysisOften, firms are compared to peer institutions in thesame industry.Large deviations from norms must be justified.For example, an industry’s median debt-to-net-worthratio might be used as a benchmark for financialleverage comparisons.Capital StructureCapital Structure -- The mix (or proportion) of a-- The mix (or proportion) of afirm’s permanent long-term financingfirm’s permanent long-term financingrepresented by debt, preferred stock, andrepresented by debt, preferred stock, andcommon stock equity.common stock equity.
    • 6-62Other Methods of AnalysisOther Methods of AnalysisFirms may gain insight into the financialmarkets’ evaluation of their firm bytalking with:Investment bankersInstitutional investorsInvestment analystsLendersSurveying Investment Analysts and LendersSurveying Investment Analysts and Lenders
    • 6-63Other Methods of AnalysisOther Methods of AnalysisFirms must consider the impactof any financing decision on thefirm’s security rating(s).Security RatingsSecurity Ratings