Capital Structures Part 2 Flashcards
A firm that designs its cost structure to include a higher degree of operating fixed costs than variable costs by electing to pay salaries instead of commissions, is magnifying the impact of each additional sales dollar using the concept of:
Operating leverage
_________________ is defined as the degree to which a firm uses debt to finance the firm, not purely operating fixed costs. When making financing decisions, a firm can choose to issue debt or equity. When debt is issued, the firm generally must pay fixed interest costs.
Financial leverage
_____________leverage results from the use of both fixed operating costs and fixed financing costs to magnify returns to the firm’s owners.
Hint: Also known as total leverage
Combined
What is the formula for operating leverage?
Op Leverage = quantity (selling price - variable cost) /
[quantity (selling price - variable cost) - Fixed costs]
A company currently has 1,000 shares of common stock outstanding with zero debt. It has the choice of raising an additional $100,000 by issuing 9% long-term debt, or issuing 500 shares of common stock. The company has a 40% tax rate. What level of earnings before interest and taxes (EBIT) would result in the same earnings per share (EPS) for the two financing options?
A. An EBIT of $27,000 would result in EPS of $10.80 for both.
B. An EBIT of $27,000 would result in EPS of $7.20 for both.
C. An EBIT of $18,000 would result in EPS of $7.20 for both.
D. An EBIT of $10,800 would result in EPS of $7.92 for both.
ANSWER - A
For Debt
EBIT - INTEREST Expense
27,000 - (100,000 x 9%) –> $18000 Operating income
40% taxes –> -$7200
Net income —> $10,800
10800 / 1000 —> $10.80 per share
Take $10.80 per share multiply times 1500 (new shares) and divide by tax rate to confirm the 27k on the equity side.
Which of the following quantitative factors, when compared to its industry average, could be an indicator of potential corporate failure?
A. High cash flow to total liabilities.
B. High retained earnings to total assets.
C. High fixed cost to total cost structure.
D. High fixed assets to non-current liabilities.
Choice “C” is correct. When fixed costs are high relative to variable costs and total
costs, the company’s operating leverage is high. What this implies is that the company
must generate enough in sales in order to meet its fixed obligations. This equates to
higher risk and could cause the company to fail if sales are not high enough.
Financial leverage increases when _____________.
Debt-to-Equity increases
AKA using a higher percentage of debt instruments (bonds/debentures).
What is the formula for EBIT?
Ebit —> Sales - Variable Expenses - Fixed Expenses
What is the formula for Financial leverage?
EBIT / EBIT - interest expense - [preferred dividends / (1 - tax rate)]
If Carlisle Company did not have preferred stock, the degree of total leverage would:
Decrease in proportion to a decrease in financial leverage.
Without preferred stock, the denominator in the total leverage calculation would be larger (because preferred stock is subtracted to arrive at the denominator). The same holds true for financial leverage. Therefore, both financial and total leverage would decrease in proportion.
What is the formula used to measure a company’s solvency (ability to meet long term obligations)?
Total liabilities / Total Assets
AKA: the debt ratio
What is the formula for times-interest-earned ratio?
Times int earned –> Earning before tax/interest (EBIT) / Total interest expense
