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