PowerPoint to accompany Chapter 13 Leverage & Capital Structure Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Learning Goals: Discuss leverage, capital structure, break-even analysis, the operating break-even point and the effects of changing costs on the break-even point. Understand the different types of leverage and the relationships between them. Describe the basic types of capital, external assessment of capital structure and capital structure theory. Explain the optimal capital structure using a graphic view of the firm’s cost of capital functions and a zero growth valuation model. Discuss the EBIT–EPS approach to capital structures. Review the return and risk of alternative capital structures and their linkage to market value, and other important considerations related to capital structure. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Leverage Results from the use of fixed cost assets or funds to magnify returns to the firm’s owners. An increase in leverage generally results in an increase in return and risk. A decrease in leverage will generally result in a decrease in risk and return. Management has control over the risk introduced through the use of leverage within an company. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Types Of Leverage Three types: Page 564. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition EBIT-EPS Approach To Capital Structure Involves selecting the capital structure that maximises EPS over the expected range of EBIT. Focuses on maximisation of earnings rather than maximisation of shareholder wealth. Five step process: 1. Obtain at least two EBIT-EPS coordinates. 2. Plot the data 3. Identify the financial break even point 4. Compare the alternative capital structures 5. Consider the risk Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Comparing Alternative Capital Structures Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Page 590. Comparing Alternative Capital Structures Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Choosing The Optimal Capital Structure The wealth maximisation goal requires us to consider both return and risk when making capital structure decisions. We must link market value with the return and risk associated with alternative capital structures. There are two ways in which this can be achieved: • Using CAPM • Linking