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DB- Determining the Financing Mix and Break-Even Analysis

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Determining the Financing Mix and Break-Even Analysis

Discussion Question:

Q- Break-even Analysis

This week we learned more about break-even analysis and its influence on decision-making. Assume you owned a coffee shop and were thinking of expanding and adding a second location within the city.

Discuss how would the use of break-even or other analysis to help you determine whether to expand or not?
Discuss the factors needed to be considered?
Discuss the assumptions needed to be made?

Directions:

Discuss the concepts, principles, and theories from your textbook. Cite your textbooks and cite any other sources if appropriate.
Your initial post should address all components of the question with a 600 word limit.

Learning Outcomes

Critique the role of business risk and financial risk in capital management.
Weigh the relationship between operating, financial, and combined leverage.
Demonstrate a break-even analysis.

Readings

Required:

Chapter 12: Determining the Financing Mix in Foundations of Finance
Nickerson, D., Lowe, M., Parrabhiramaiah, A., & Sorecu, A. (2021). The impact of corporate social responsibility on brand sales: An accountability perspective. Journal of Marketing, 86(2), 5–28.
Xue, Y., Jiang, C., Guo, Y., Liu, J., Wu, H., & Hao, Y. (2022). Corporate social responsibility and high-quality development: Do green innovation, environmental investment and corporate governance matter? Emerging Markets Finance & Trade, 58(11), 3191-3214.

Recommended:

Chapter 12 PowerPoint Slides
Su, S. X., Baird, K., & Nuhu, N. (2021). Controllability of performance measures and managerial performance: the mediating role of fairness. Meditari Accountancy Research, 30(2), 313–341.

Foundations of Finance
Tenth Edition

Chapter 12
Determining the Financing Mix

Learning Objectives
12.1 Distinguish between business and financial risk.
12.2 Use break-even analysis.

12.3 Understand the relationship between operating,
financial, and combined leverage.
12.4 Discuss the concept of an optimal capital structure.
12.5 Use the basic tools of capital structure management.

Figure 12.1 The Cost of Capital as a
Link Between a Firm’s Asset
Structure and Capital Structure

Understanding the Difference
Between Business and Financial
Risk

Risk
• Risk is variability associated with expected revenue or
income streams. Such variability may arise due to three
sources:
– Choice of business line (business risk)
– Choice of an operating cost structure (operating risk)
– Choice of a capital structure (financial risk)

Business Risk
• Business risk is the variation in the firm’s expected
earnings attributable to the industry in which the firm
operates. There are four determinants of business risk:
– The stability of the domestic economy
– The exposure to, and stability of, foreign economies
– Sensitivity to the business cycle
– Competitive pressures in the firm’s industry

Operating Risk
• Operating risk is the variation in the firm’s operating
earnings that results from firm’s cost structure (mix of fixed
and variable operating costs).
• Earnings of firms with higher proportion of fixed operating
costs are more vulnerable to change in revenues.

Financial Risk
• Financial risk is the variation in earnings as a result of
firm’s financing mix or proportion of financing that requires
a fixed return.

Break-Even Analysis (1 of 3)

Break-Even Analysis (2 of 3)
• Break-even analysis is used to determine the breakeven quantity of a firm’s output by examining the
relationships among the firm’s cost structure, volume
of output, and profit.
• Break-even quantity may be calculated in units or
sales dollars.
• Break-even point indicates the point of sales or units at
which earnings before interest and taxes (EBIT) is
equal to zero.

Break-Even Analysis (3 of 3)
• Use of break-even model enables the financial manager
to
– Determine the quantity of output that must be sold to
cover all operating costs, as distinct from financial
costs
– Calculate the EBIT that will be achieved at various
output levels

Essential Elements of the BreakEven Model (1 of 2)
• Break-even analysis requires information on the
following:
– Fixed costs
– Variable costs
– Total revenue
– Total volume

Essential Elements of the BreakEven Model (2 of 2)
• Break-even analysis requires classification of costs into
two categories:
– Fixed costs
– Variable costs
• Because all costs are variable in the long run, break-even
analysis is a short-run concept.

Fixed Costs
• These costs do not vary in total amount as sales volume
or the quantity of output changes.
– As production volume increases, fixed costs per unit
of product falls, as fixed costs are spread over a
larger and larger quantity of output (but total remains
the same).
– Fixed costs vary per unit but remain fixed in total.
– The total fixed costs are generally fixed for a specific
range of output.

Fixed Costs Examples
1. Administrative salaries
2. Depreciation
3. Insurance
4. Lump sums spent on intermittent advertising programs
5. Property taxes
6. Rent

Variable Costs
• Variable costs vary as output changes. Thus if production
is increased by 10 percent, total variable costs will also
increase by 10 percent.

Variable Costs Examples
1. Direct labor
2. Direct materials
3. Energy costs (fuel, electricity, natural gas) associated
with the production
4. Freight costs
5. Packaging
6. Sales commissions

Figure 12.2 The Behavior of Total,
Fixed, and Variable Costs over a
Relevant Range of Output

Figure 12.3 Semivariable Cost
Behavior over a Relevant Range of
Output

Revenue
• Total revenue is the total sales dollars.

• Total revenue = P × Q
P = selling price per unit
Q = quantity sold

Volume
• The volume of output refers to the firm’s level of
operations and may be indicated either as a unit quantity
or as sales dollars.

Break-Even Point (BEP)
• BEP = Point at which EBIT equals zero (sales price per
unit) × (units sold) − [(variable cost per unit) ×(units sold)
+ (total fixed cost)] = EBIT = $0

Example
1. Fixed costs = $100,000
2. Sales price per unit = $10
3. Variable cost per unit = $6
•

• If the firm sells 25,000 units, EBIT will be equal to zero
dollars.
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved

Table 12.1 Income Statement for
Pierce Grain Company

Example in Dollars

Sources of Operating Leverage

Operating Leverage (1 of 4)
• Operating leverage measures the sensitivity of the firm’s
EBIT to fluctuation in sales when a firm has fixed
operating costs.
• If the firm has no fixed operating costs, EBIT will change
in proportion to the change in sales.

Operating Leverage (2 of 4)
• Operating Leverage (OL)
• Thus % change in EBIT = OL × % change in sales
Where:
% change in EBIT

% change in sales

Operating Leverage (3 of 4)
• Example: If a company has an operating leverage (OL) of
6, then what is the change in EBIT if sales increase by 5
percent?
% change in EBIT = OL × % change in sales
= 6 × 5% = 30%
• Thus, if the firm increases sales by 5 percent, EBIT will
increase by 30 percent

Operating Leverage (4 of 4)
• Operating leverage is present when

• The greater the firm’s degree of operating leverage, the
more the profits will vary in response to change in sales.

Table 12.2 How Operating Leverage
Affects EBIT: An Increase in Pierce
Grain Company’s Sales

Operating Leverage for Pierce Grain
• Due to operating leverage, even though the sales
increase by only 20 percent, EBIT increases by 120
percent. (And vice versa: if sales drop by 20 percent,
EBIT will fall by 120 percent; see Table 12.3.)
• If Pierce had no operating leverage (i.e., all of its
operating costs were variable), then the increase in EBIT
would have been in proportion to increase in sales (i.e.,
20 percent).

Table 12.3 How Operating Leverage
Affects EBIT: A Decrease in Pierce
Grain Company’s Sales

Financial Leverage
• Financial leverage means financing a portion of the firm’s
assets with securities bearing a fixed (limited) rate of
return in hopes of increasing the return to the common
stockholders.
• Thus the decision to use preferred stock or debt exposes
the common stockholders to financial risk.
• Variability of EBIT is magnified by the firm’s use of
financial leverage.

Table 12.4 Possible Capital
Structures for Pierce Grain Company

Three Capital Structure Plans
• Plan A: 0% debt—no financial risk
• Plan B: 25% debt—moderate financial risk

• Plan C: 40% debt—higher financial risk
• See Table 12.5 for impact of financial leverage on
earnings per share (EPS). The use of financial leverage
magnifies the impact of changes in EBIT on earnings per
share.

Table 12.5 An Analysis of Financial Leverage at
Different EBIT Levels: Pierce Grain Company

Capital Structure Plans
• A firm employing financial leverage is exposing its owners
to financial risk when percentage change in EPS divided
by percentage change in EBIT is greater than 1.00.

Combined Leverage (1 of 2)
• Operating leverage causes changes in sales revenues to
cause even greater changes in EBIT. Furthermore,
changes in EBIT due to financial leverage create large
variations in both EPS and total earnings available to
common shareholders.
• Not surprisingly, combining operating and financial
leverage causes rather large variations in EPS.

Combined Leverage (2 of 2)
• Combined Leverage
• Or Combined Leverage = Operating Leverage × Financial
Leverage

Figure 12.4 Leverage and Earnings
Fluctuations

Combining Operating and Financial
Leverage
• Table 12.6 shows that a modest 20 percent increase in
sales revenue translates to 150 percentage increase in
EPS due to the combined leverage effect.

Table 12.6 The Combined-Leverage Effect on
Pierce Grain Company’s Earnings per Share

Capital Structure Theory

Financial and Capital Structure
• Financial Structure
– Mix of all items that appear on the right-hand side of
the company’s balance sheet (see Table 12.7).
• Capital Structure
– Mix of the long-term sources of funds used by the firm
– Capital Structure = Financial Structure − Non-interestbearing liabilities (accounts payable, accrued
expenses)

Table 12.7 Distinguishing Between a
Firm’s Financial Structure and Its
Capital Structure

Designing a Capital Structure
• Designing a prudent capital structure requires answers
to the following:
• Debt maturity composition: How should a firm best
divide its total fund sources between short-term and
long-term debt components?
• Debt-equity composition: What mix of debt and equity
should the firm use?

Capital Structure Management
• A firm should mix the permanent sources of funds in a
manner that will maximize the company’s stock price, or
minimize the cost of capital.
• A proper mix of fund sources is called the “optimal capital
structure.”

A Quick Look at Capital Structure
Theory
• Theory focuses on the effect of financial leverage on the
overall cost of capital to the enterprise.

• In other words, can the firm affect its overall cost of
funds, either favorably or unfavorably, by varying the
mixture of financing used?
• Firms strive to minimize the cost of using financial capital
so as to maximize shareholder’s wealth.

Independence Position
• According to Modigliani and Miller, the total value of the
firm is not influenced by the firm’s capital structure. In
other words, the financing decision is irrelevant!
• Their conclusions were based on restrictive assumptions
(such as no taxes, capital structure consisting of only
stocks and bonds, perfect or efficient markets).

Financing Mix (1 of 2)
• Figure 12.5 shows that the firm’s value remains the
same, despite the differences in financing mix.
• Figure 12.6 shows that the firm’s cost of capital remains
constant, although cost of equity rises with increased
leverage.

Figure 12.5 Firm Value and Capital
Structure Design

Figure 12.6 Capital Costs and
Financial Leverage: No Taxes—
Independence Hypothesis

Financing Mix (2 of 2)
• The implication of these figures for financial managers is
that one capital structure is just as good as any other.
• However, the above conclusion is possible only under
strict assumptions.
• We next turn to a market and legal environment that
relaxes these restrictive assumptions.

Extensions to Independence
Hypothesis: The Moderate Position
• The moderate position considers how the capital structure
decision is affected when we consider the following:
– Interest expense is tax deductible (a benefit of debt)
– Debt financing increases the risk of default (a
disadvantage of debt)
• Combining the above (benefit and drawback) provides a
conceptual basis for designing a prudent capital structure.

Impact of Taxes on Capital Structure
(1 of 3)
• Interest expense is tax deductible.
• Because interest is deductible, the use of debt financing
should result in higher total market value for firms
outstanding securities.

• r = rate, m = principal, t = marginal tax rate

Table 12.8 Skip’s Camper Cash
Flows to All Investors—The Case of
Taxes

Impact of Taxes on Capital Structure
(2 of 3)
• Because interest on debt is tax deductible, the higher the
interest expense, the lower the taxes.
• Thus, one could suggest that firms should maximize debt
… indeed, firms should go for 100 percent debt to
maximize tax shield benefits!!
• But we generally do not see 100 percent debt in the real
world … why not?

Impact of Taxes on Capital Structure
(3 of 3)
• One possible explanation
– Bankruptcy costs

Impact of Bankruptcy on Capital
Structure (1 of 2)
• The probability that a firm will be unable to meet its debt
obligations increases with debt. Thus probability of
bankruptcy (and hence costs) increase with increased
leverage. Threat of financial distress causes the cost of
debt to rise.
• As financial conditions weaken, expected costs of default
can be large enough to outweigh the tax shield benefit of
debt financing.

Impact of Bankruptcy on Capital
Structure (2 of 2)
• So, higher debt does not always lead to a higher value …
after a point, debt reduces the value of the firm to
shareholders.

• This explains a firm’s tendency to restrain itself from
maximizing the use of debt.
• Debt capacity indicates the maximum proportion of debt
the firm can include in its capital structure and still
maintain its lowest composite cost of capital (see Figure
12.7).

Figure 12.7 Capital Costs and Financial
Leverage: The Moderate View,
Considering Taxes and Financial Distress

Firm Value and Agency Costs
• To ensure that agent-managers act in shareholders best
interest, firms must
1. Have proper incentives
2. Monitor decisions
– Bonding the managers
– Auditing financial statements
– Structuring the organization in unique ways that limit
useful managerial decisions
– Reviewing the costs and benefits of management
perquisites
• The costs of the incentives and monitoring must be borne
by the stockholders.
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved

Impact of Agency Costs on Capital
Structure (1 of 3)
• Capital structure management also gives rise to agency
costs. Bondholders are principals because essentially they
have given a loan to the corporation, which is owned by
shareholders.
• Agency problems stem from conflicts of interest between
stockholders and bondholders. For example, pursuing
risky projects may benefit stockholders but may not be
appreciated by bondholders.
• Bondholders’ greatest fear is default by corporation or
misuse of funds leading to financial distress.
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved

Impact of Agency Costs on Capital
Structure (2 of 3)
• Agency costs may be minimized by agreeing to include
several protective covenants in the bond contract.
• Bond covenants impose costs (such as periodic
disclosure) and impose constraints (on type of project
that management can undertake, collateral, distribution of
dividends, limits on further borrowing).
• Agency costs depend on the level of debt. At lower levels
of debt, creditors may not insist on a long list of bond
covenants to monitor. Thus, agency cost and cost of
financing are reduced at lower levels of debt.
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved

Impact of Agency Costs on Capital
Structure (3 of 3)
• Figure 12.8 indicates the trade-offs. For example,
increasing the protective covenants will reduce the interest
cost but increase the monitoring cost (which is eventually
borne by the shareholders).

Figure 12.8 The Agency Costs of
Debt: Trade-Offs

Managerial Implications
• Determining the firm’s financing mix is critically important
for the manager.
• We observe that the decision to maximize the market
value of leveraged firm is influenced primarily by the
present value of tax shield benefits, present value of
bankruptcy costs, and present value of agency costs.

The Basic Tools of Capital Structure
Management

Basic Tools
• Two basic tools are used to evaluate capital structure
decisions:
– EBIT-EPS analysis
– Financial leverage ratios

EBIT-EPS Analysis
• Managers care about EPS because it sends an important
signal to the market about future prospects and will affect
the stock prices

• The EBIT-EPS chart provides a way to visualize the
effects of alternative capital structure on both the level and
volatility of the firm’s earning per share (EPS).

Figure 12.9 EBIT-EPS Analysis Chart
for Pierce Grain Company

EBIT-EPS Chart
• The chart shows that at a specific level of EBIT, stock and
bond plan produce different EPS (except at the
intersection point with EBIT = $21,000 where EPS is
equal to $6.72 under both plans).
• Above the intersection point, EPS will be higher for plan
with greater leverage (and vice versa).
• For example, at EBIT of $30,000
– EPS using bond plan = $11.46
– EPS using stock plan = $10.27

Finding the Intersection or EBITEPS Indifference Point (1 of 2)
• Compare EPS-stock plan versus EPS-bond plan
and solve for EBIT in the following two equations:

Finding the Intersection or EBITEPS Indifference Point (2 of 2)
• EPS-EBIT chart is simply a tool to analyze capital
structure decision.
• Thus, achieving a high EPS based on high leverage may
not be the right decision.

• The final decision will be made after weighing all factors.

Table 12.9 Analyzing Pierce Grain
Company’s Financing Choices

Comparative Leverage Ratios
• Two types of ratios (as covered in Chapter 4), balance
sheet leverage ratios and coverage ratios, can be
computed and compared to industry norms.

• If the ratios are significantly different from industry
average, the managers must analyze further.

Financial Analysis
• To assess a firm’s financial leverage, analysts will
generally use the net debt ratio.
• Companies who are able to pay some or all of their debt
with excess cash have less risk exposure.

Capital Structure Determinants
(Survey Results) (1 of 4)
• A survey of 392 corporate executives revealed the
following 10 factors as important determinants of capital
structure decision:
• Financial flexibility
– Firm’s bargaining position is stronger if it has choices.
• Credit rating
– Downgrading of credit rating will increase borrowing
costs and thus managers try to avoid anything that will
trigger credit downgrades.
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved

Capital Structure Determinants
(Survey Results) (2 of 4)
• Insufficient internal funds
– Firms follow a pecking order for raising funds – internal
funds followed by debt and then equity.
• Level of interest rates
– Firms tend to borrow when interest rates are low
relative to their expectations.
• Interest tax savings
– Debt is cheaper due to the tax benefit on interest paid.
Dividend distribution does not receive any tax benefit.
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved

Capital Structure Determinants
(Survey Results) (3 of 4)
• Transaction costs and fees
– Cost of issuing equity is relatively higher than debt,
making equity a less attractive source.
• Equity valuation
– If shares are undervalued, firms will like to issue debt,
and vice versa. Thus, valuation impacts the timing of
security issue.
• Comparable firm debt levels
– Firms from similar businesses tend to have similar
capital structures.
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved

Capital Structure Determinants
(Survey Results) (4 of 4)
• Bankruptcy/distress costs
– Higher level of existing debt will increase the likelihood
of financial distress.
• Customer/supplier discomfort
– High levels of debt will increase discomfort among
customer (fearing disruption in supply) and suppliers
(fearing disruption in demand and late/nonpayment on
existing contracts).

Key Terms (1 of 3)
• Balance sheet leverage ratios
• Break-even quantity
• Business risk
• Capital structure
• Combined, or total, leverage

• Coverage ratios
• Debt capacity
• Debt-equity composition

Key Terms (2 of 3)
• Debt maturity composition
• EBIT-EPS indifference point

• Financial leverage
• Financial risk
• Financial structure

• Fixed costs
• Net debt

Key Terms (3 of 3)
• Operating risk
• Operating leverage
• Optimal capital structure

• Optimal range of financial leverage
• Tax shield
• Total revenue

• Variable costs
• Volume of output

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Determining the Financing Mix and Break-Even
Analysis
Discussion Question:
Q- Break-even Analysis
This week we learned more about break-even analysis and its influence on decision-making. Assume
you owned a coffee shop and were thinking of expanding and adding a second location within the city.
• Discuss how would the use of break-even or other analysis to help you determine whether to
expand or not?
• Discuss the factors needed to be considered?
• Discuss the assumptions needed to be made?
Directions:
• Discuss the concepts, principles, and theories from your textbook. Cite your textbooks and
cite any other sources if appropriate.
• Your initial post should address all components of the question with a 600 word limit.

Learning Outcomes
1. Critique the role of business risk and financial risk in capital management.
2. Weigh the relationship between operating, financial, and combined leverage.
3. Demonstrate a break-even analysis.
Readings
Required:
• Chapter 12: Determining the Financing Mix in Foundations of Finance
• Nickerson, D., Lowe, M., Parrabhiramaiah, A., & Sorecu, A. (2021). The impact of corporate
social responsibility on brand sales: An accountability perspective. Journal of
Marketing, 86(2), 5–28.
• Xue, Y., Jiang, C., Guo, Y., Liu, J., Wu, H., & Hao, Y. (2022). Corporate social responsibility
and high-quality development: Do green innovation, environmental investment and corporate
governance matter? Emerging Markets Finance & Trade, 58(11), 3191-3214.
Recommended:
• Chapter 12 PowerPoint Slides
• Su, S. X., Baird, K., & Nuhu, N. (2021). Controllability of performance measures and
managerial performance: the mediating role of fairness. Meditari Accountancy
Research, 30(2), 313–341.

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