Financial management -- Chapter 12 -- summary

The amount of leverage (fixed cost assets or funds) employed by a firm directly affects its risk, return, and share value. Generally, higher leverage raises risk and return, and lower leverage reduces risk and return. Operating leverage is concerned with the level of fixed operating costs; financial leverage focuses on fixed financial costs, particularly interest on debt and any preferred stock dividends. The firm's financial leverage is determined by its capital structure. Because of its fixed interest payments, the more debt a firm employees relative to its equity, the greater its financial leverage.

The value of the firm is clearly affected by its degree of operating leverage and by the composition of its capital structure. The financial manager must therefore carefully consider the types of operating and financial costs it concurs, recognizing that with greater fixed costs comes higher risk. Major decisions with regard to both operating cost structure and capital structure must therefore focus on their impact on the firm's value. Only those leverage and capital structure decisions that are consistent with the firm's goal of maximizing its stock price should be implemented.

Effects of changing costs
Leverage results from the use of fixed costs to magnify returns to a firm's owners. Capital structure, the firm's mix of long-term debt and equity, affects leverage and therefore the firm's value. Breakeven analysis measures the level of sales necessary to cover total operating costs. The operating breakeven point may be calculated algebraically, by dividing fixed operating costs by the difference between the sale price per unit and variable operating cost per unit, or it may be determined graphically. The operating breakeven point increases with increased fixed and variable operating costs and decreases than increase in sale price, and vice versa.

Leverages
Operating leverage is the use of fixed operating costs by the firm to magnify the effects of changes in sales on EBIT. The higher the fixed operating costs, the greater the operating leverage. Financial leverage is the use of fixed financial costs by the firm to magnify the effects of changes in EBIT on EPS. The higher the fixed financial costs, the greater the financial leverage. The total leverage of the firm is the use of fixed costs -- both operating and financial -- to magnify the effects of changes in sales on EPS.

Non-US firms and capital structure theory
Debt capital and equity capital make up a firm's capital structure. Capital structure can be externally assessed by using financial ratios -- debt ratio, Times interest earned ratio, and fixed payment coverage ratio. Non-US companies try to have much higher degrees up indebtedness then do their US counterparts, primarily because US capital markets are much more developed.

Research suggests that there is an optical capital structure that balances the firm's benefits and costs of debt financing. The major benefit of debt financing is the tax shield. The costs of debt financing include the probability of bankruptcy; agency costs imposed by lenders; and asymmetric information, which typically causes firms to raise funds in a pecking order so as to send positive signals to the market and thereby enhance shareholder wealth.

Optimal capital structure
Zero growth valuation model defines the firm's value as its net operating profit after taxes (NOPAT), or after-tax EBIT, divided by its weighted average cost of capital. Assuming that NOPAT is consistent, the value of the firm is maximized by minimizing its weighted average cost of capital (WACC). The optimal capital structure is one that minimizes the WACC. Graphically, the firm's WACC exhibit a U-shaped, whose minimum value defines the optimal capital structure that maximizes owner wealth.

EBIT-EPS
the EBIT-EPS approach evaluates capital structures in light of the returns they provide the firm's owners and their degree of financial risk. Under the EBIT-EPS approach, the preferred capital structure is the one that is expected to provide maximum EPS over the firm's expected range of EBIT. Graphically, this approach reflects risk in terms of the financial breakeven point and the slope of the capital structure line. The major shortcoming of EBIT-EPS analysis is that it concentrates on maximizing earnings (returns) rather than owner's wealth, which considers risk as well as return.

Return and risk of alternative capital structures
The best capital structure can be selected by using a valuation model to leak return and risk factors. The preferred capital structure is the one that results in the highest estimated share value, not the highest EPS. Other important non-quantitative factors must also be considered when making capital structure decisions.