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Optimal Operating and Financial Leverage
Transcript of Optimal Operating and Financial Leverage
New demand on the market:
People want more natural light in their buildings
Rapid growth of custom windows
Disadvantages of these windows: increased cost of H&C
2 PLAN B
3 TIE AS A RISK MEASURE
TIE ratio is 8,28
EBIT is 8,28 times higher than the interest payable
average industry ratio is 6
the company has a relatively high margin of safety
could be beneficial, if the firm would like to attempt to borrow additional funds
5 DEBT LEVEL AND ASSET HOLDINGS
Should we invest all our assets in this company?
Does the level of debt matters?
"Don't put all your eggs in one basket!"
7 INFORMATION ASYMMETRIES
Options of financing for a company:
Internal sources for investment projects (using retain earnings) - THE BEST
Share issuing - THE WORST
MATURE Inc: managers are sending signals about the value of shares to investors
If value is lower comparing market price, they issue shares - BAD SIGNAL
If value is higher, they issue bonds - GOOD SIGNAL
Signaling is not working with:
IPO: it's expensive, however it can bring bigger amount of money
Example of Facebook (500 shareholders, investments from companies, $50 billion valuation and Twitter ($31 billion) - GOOD SIGNAL
START-UPS: VC or private equity to boost further growth, no bank loan, no issuing
Market does not always work on theoretical principles.
annual fixed costs: $7,769 million
variable costs: $585 per unit produced
investment: $14 million
4 DEBT SERVICE COVERAGE RATIO
"DSCR 4.45 means that there is enough net operating income to cover 4.45-times of annual debt payments and the Company is less risky than average (4) manufacturing company."
ESTIMATIONS OF Kd and Ks
8 CONTROL OF THE COMPANY
"More the equity is dispersed among numerous shareholders, more difficult the shareholders control the decision of the managers.
To prevent current management to lose control of the company they could decide to issue different types of common stock like Class A and Class B."
Johnson Window Company case study
NUMBER AND VALUE OF SHARES
62,68% of equity
price of share is $10,00
investor receive 1.200.000
value of their shares $12,000.000
founders receive 143.824 shares
value of their shares $1,438,240,00
DIFFERENT PURCHASE PRICES AND LEGAL RISK
" Usually the issuing company performs a due-diligence which provides a defense to signatories of the prospectus and others in the event of an action for misrepresentation."
MAXIMIZATION OF VALUE OF THE FIRM
THE VALIDITY OF ASSUMPTIONS
Perpetual cash flows?
No dividend pay outs?
9 LOWER TAX RATE
10 CHANGE IN VARIABLE COSTS
Higher variable cost per unit $585 to $625
higher variable cost
higher break even point
What cost structure? What capital structure?
Plan A : lower operating leverage, lower CV and SD, lower Qbe, PROFITABLE
Plan B : higher operating leverage, higher CV and SD, profitable, RISKIER
But, is it worth taking the risk?
- optimal capital structure (debt&equity)
- higher enterprise value
- better TIE and DSCR than average manufacturing firm
- pay attention to the distribution of stock and the control of the firm
- pay attention to legal risk
- pay attention to the change in estimations of Kd and Ks
- change in variable costs can render Plan A riskier and raise QbeA above QbeB
Higher operating leverage, financial leverage, higher Qbe but enough EBIT to service debt and stockholders expectations (manageable risk) .
Maximization of stakeholder value.
So, let's go for Plan B!
1 PRODUCTION PLAN
40% firm's tax rate
level of financial leverage is 37,32%
capital structure of 37,32% of debt
62,68% of equity the capital structure
Lower or higher level of debt the value of the firm would be lower. Why? The interest payment is tax deductible.
WACC is negatively correlated with the value of the firm: at higher rate of WACC the value of the firm is lower.
lower break even point
low operating leverage
lower level of business risk
higher break even point
higher operating leverage
higher level of business risk
GOOD TIMES BAD TIMES
annual fixed costs: $17,845 million
variable costs: $415 per unit
investment: $20 million.
Perpetual cash flows can be estimated on the basis of the expected EBIT
DSCR=$4,767,050/$1,071,030 = 4.45
Calculating with financial calculator:
N= 20 years (time period) ,
i= 12% (cost of debt),
PV = -$8 million (amount of debt) ;
FV= 0 →
PMT = $1,071,030 (annuity)
DSCR=EBIT/(Total Debt Service)
Comparison of production plan A and B
Optimal capital structure for plan B
Risk assessment of plan B
Change in assumptions of Kd and Ks of Plan B
Change in tax rate of Plan B
Change in variable costs of Plan A
Johnson developed and patented tinted glass window
Change of color with brightness of the sun
Reducing heating and cooling costs
Target market segment: offices and apartment buildings
Disadvantage: 75 % greater in price BUT the price makes up for difference in 5 years (outsourced estimation)
Founders of start-up: Johnson, production engineer and finance specialist
Significant ownership interest
Little trouble in raising outside debt or equity capital
Local banks, insurance companies and VC!
What is the optimal operational and financial leverage?