FMA 101 Topic 10 – Leverage and Capital Structure Assignment Answers

 

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FMA 101 Topic 10 LEARNING OUTCOMES :

After completing this topic, you should be able to:

  • Define and explain the origin of leverage, the capital structure of a business entity, the role and purpose of break-even analysis, the operating break-even point and the effect of changing costs on the operating break-even point.
  • Calculate the operating break-even point for a business entity for normal operations and changes in costs in physical units and money terms using formulas and illustrations and then analyse and interpret the outcomes of such calculations and illustrations.
  • Calculate the operating leverage, financial leverage and total leverage for a business entity using formulas and then analyse and interpret the outcomes of such calculations.
  • Distinguish between and explain the types of capital in a capital structure and explain the external assessment of the capital structure of non-RSA firms, the capital structure theory, tax benefits associated with a capital structure, the probability of bankruptcy and the imposition of agency costs by lenders.
  • Explain, determine and illustrate the optimal capital structure that maximises the value of a firm using a modified zero-growth valuation model as well as the firm’s weighted average cost of capital.

 

READING FMA 101 Topic 10 :

Before continuing with this topic, please read the following:

  • Gitman et al. (2015: Chapter 13)

Please make sure that you also read this study guide carefully as it contains additional information that is not in the prescribed textbook.

 

 

FMA 101 LEVERAGE

You must study the content of this chapter in detail and be able to calculate leverage and break-even points both mathematically and graphically.

 

The key concepts that you must focus on are:

  • leverage
  • operating leverage
  • financial leverage
  • total leverage

 

The content of this chapter covers two very important aspects of financial management, namely break-even analysis and leverage.

 

Leverage refers to the use of fixed-cost assets to improve the return on investment for owners of the business. It assists the financial manager with techniques that will enable him/her to strike the best balance between the use of own and borrowed funds to fund the activities of the organisation.

 

 

Leverage is also referred to as gearing. A business that uses too much borrowed funds (debt) to fund its operations makes investors nervous, because the lenders of such funds then bear the bigger part of the business risk. If the business runs into difficulties, the lenders have the most to lose.

 

On the other hand, if an organisation does not use any external funding, it also makes investors nervous because they wonder if lenders are refusing to lend the business money because they consider the business too high a risk to invest in.

 

 

A business must, therefore, have a capital structure in place that does not include either too much or too little debt to appease investors and lenders alike.

 

 

You must be able to distinguish between the different categories of leverage found in organisations and explain their differences. Table 13.1 in the prescribed textbook provides a very useful demonstration of the different types of leverage categories in the context of a statement of comprehensive income.

 

 

FMA 101 BREAK-EVEN ANALYSIS

The key concepts that you must focus on are:

  • break-even analysis
  • operating break-even point (OBP)
  • fixed cost
  • variable operating cost per unit
  • selling price per unit

 

Break-even analysis is also known as cost-volume-profit (CVP) analysis.

 

 

You must be able to explain and discuss the meaning of break-even analysis and its purpose in business entities.

 

You must be able to provide a definition for an operating break-even point and explain the relationship between earnings before interest and tax and selling price, and variable operating cost and fixed cost.

Study Table 13.2 and the deduction of the formula used to calculate an operating break-even point as illustrated by Formulas 13.1, 13.2 and 13.3 in the prescribed textbook.

 

You must be able to determine and express operating break-even points in physical units, monetary terms or time units using relevant formulas and/or graphs and calculate, explain and demonstrate the effects of cost changes on operating break-even points.

You must study Example 13.1 as well as Figure 13.1 in the prescribed textbook. Example 13.1 explains and demonstrates how to calculate the operating break- even point for a business entity in physical units (quantity).

The operating break-even point can also be expressed in monetary terms as follows:

OBP in rand = OBP in units × Selling price per unit

OBP (rand) = ( FC ) /P – VC× Selling price/unit

 

Figure 13.1 illustrates how the operating break-even point can be determined by plotting the fixed cost, total variable operating cost and sales revenue curves on a graph.

You should take note of the following relationship between fixed cost and total variable cost:

  • Total cost = Fixed cost + Total variable cost
  • TC = FC + VC
  • Total revenue = Selling price/unit × Number of units
  • TR = P × Q

 

The operating break-even point in Figure 13.1 is found at the point where Total revenue (TR) = Total cost (TC)

 

You must be able to calculate operating break-even points when there are changes in the selling price, variable cost or fixed cost or a combination of these variables.

 

Study Table 13.3 and Example 13.2 in the prescribed textbook. They explain and demonstrate the effects of changes in the different elements of operating break- even analysis on the operating break-even point.

 

Example 13.3 in the prescribed textbook explains and demonstrates how the time it may take an entity to achieve its operating break-even point can be calculated. You need to study this example carefully and make sure that you understand the calculations involved.

 

FMA 101 OPERATING LEVERAGE

The key concepts that you must focus on are:

  • definition of operating leverage
  • earnings before interest and tax (EBIT)
  • percentage change in EBIT
  • percentage change in sales
  • degree of operating leverage (DOL)

 

You need to be able to define operating leverage. You need to understand that operating leverage refers to the use of fixed operating costs to increase the effect that an increase in sales will have on the EBIT of a business entity.

 

Operating leverage, therefore, measures the magnitude of the effect that a change in sales will have on the operating profit of a business.

 

To better understand this relationship between changes in sales and EBIT, you need to study Example 13.4 and Table 13.2 in the prescribed textbook.

 

Table 13.2 illustrates how an increase in units of product sold (increase in sales) increases the EBIT. An increase of 1 500 – 1 000 = 500 units of product results in an increase in EBIT by R5 000 – R2 500 = R2 500.

 

A 50% increase in sales (500/1 000) results in a 100% (2 500/2 500) increase in EBIT.

 

The extent to which a change in sales affects the EBIT of a business entity is known as the degree of operating leverage (DOL).

 

The DOL is a number which indicates by how much EBIT will change for a specific change in sales revenue and can be calculated as follows:

𝐃OL = % change in EBIT / % change in sales revenue

 

You must take note that the formula requires two sets of calculations because it measures:

  • a change in sales and a change in EBIT
  • the changes expressed as percentages

 

You can calculate the change that occurred in sales revenue or EBIT only if you have the sales revenue and EBIT amounts for TWO periods.

 

Students generally find it challenging to calculate percentage changes in variables. Table 10.1 demonstrates how the change in the two variables are calculated and then how the changes are converted to percentage changes.

Table 10.1            Calculating percentage change in variables

2020

(B)

2019

(A)

Change

C = (B – A)

% change

(C/A) × 100

Sales revenue 2 500 000 1 900 000 600 000 32%
EBIT 1 450 000 980 000 470 000 48%

 

The degree of operating leverage for the information in Table 10.1 can be calculated as follows:

 

 

𝐃OL = % change in EBIT/% change in sales revenue

𝐃OL = 48%/32%

𝐃OL = 1.5

 

A DOL = 1.5 means that for every R1.00 increase (decrease) in sales revenue, the EBIT (operating profit) of the business will increase (decrease) by R1.50.

You need to bear in mind that operating leverage works both ways. While an increase in sales will lead to an increase in EBIT, the opposite is equally true. A decrease in sales will lead to a decrease in EBIT.

 

DOL AT BASE LEVEL

Example 13.6 and Formula 13.5 in the prescribed textbook explain and demonstrate how the DOL can be calculated given a specified number of units of product sold.

 

The formula for DOL at a specified quantity (X units) is stated as follows:

DOL at X units= Q × (P – VC)/Q × (P – VC) – FC

 

The DOL can also be calculated if only the total sales revenue and total variable cost amounts are known. The formula to use in such a scenario is:

DOL at sales in rand = Total revenue (TR) – Total variable cost (TVC)/TR – TVC – FC

 

FIXED COSTS AND OPERATING LEVERAGE

Changes in fixed cost will affect the operating leverage because fixed cost is an integral element in the calculation of operating leverage.

You need to be able to explain and demonstrate how changes in fixed cost affect operating leverage.

Study Example 13.7 and Table 13.5 in the prescribed textbook. The example and content of the table explain and demonstrate the effect of changes in fixed cost on operating leverage.

 

FMA 101 FINANCIAL LEVERAGE

The key concepts that you must focus on are:

  • definition of financial leverage
  • earnings per share (EPS)
  • percentage change in EPS
  • percentage change in EBIT
  • degree of financial leverage (DFL)

You need to be able to define financial leverage. You need to understand that financial leverage refers to the use of fixed financing costs to increase the effect that an increase in EBIT will have on the earnings per share (EPS) of a business entity.

 

Financial leverage, therefore, measures the magnitude of the effect that a change in EBIT will have on the earnings per share of a business.

 

To better understand this relationship between changes in EBIT and EPS, you need to study Table 13.6 and Example 13.8 in the prescribed textbook.

 

Table 13.6 illustrates how a change in EBIT affects the EPS of an entity. An increase in EBIT of R140 000 – R100 000 = R40 000 results in an increase in EPS from R2.80 to R5.60 or R5.60 – R2.80 = R2.80.

 

A 40% increase in EBIT (R40 000/R100 000) results in a 100% (R2.80/R2.80) increase in EBIT.

 

The extent to which a change in EBIT affects the EPS of a business entity is known as the degree of financial leverage (DFL).

 

The DFL is a number which indicates by how much EPS will change for a specific change in EBIT and can be calculated as follows:

𝐃FL =% change in EPS/% change in EBIT

 

You must take note that the formula requires two sets of calculations because it measures:

  • a change in EBIT and a change in EPS
  • the changes expressed as percentages

 

You can calculate the change that occurred in EBIT or EPS only if you have the EBIT and EPS for TWO periods.

 

The degree of financial leverage for the information in Table 13.6 is calculated  as follows:

𝐃FL = % change in EPS/% change in EBIT

𝐃FL = 100%/40%

𝐃FL = 2.5

 

A DFL = 2.5 means that for every R1.00 increase (decrease) in EBIT, the EPS of the business will increase (decrease) by R2.50.

You need to bear in mind that financial leverage works both ways. While an increase in EBIT will lead to an increase in EPS, the opposite is equally true. A decrease in EBIT will lead to a decrease in EPS.

 

FMA 101 THE IMPACT OF ADDITIONAL DEBT

Should a business entity decide to increase the amount of debt it has by borrowing more funds from lenders, the fixed financial costs will increase because additional interest on debt is added to the existing interest on debt (financial cost).

 

The increase in financial cost will affect the EBIT and hence also the EPS of the business entity.

 

You must be able to calculate and assess the effects of an increase in debt on the degree of financial leverage of a business entity as well as the effect on the EPS of the entity.

 

Study Example 13.10 in the prescribed textbook. This example both explains and demonstrates how an increase in fixed finance cost will affect the DFL.

 

THE DFL AT BASE LEVEL

Example 13.11 and Formula 13.7 in the prescribed textbook explain and demonstrate how the DFL can be calculated given a specified level of EBIT.

 

The formula for DFL at a specified EBIT level is stated as follows:

DFL at base level EBIT =EBIT/EBIT – 1 – (PD × (1 – 1/Tax rate))

 

TOTAL LEVERAGE

The key concepts that you must focus on are:

  • definition of total leverage
  • degree of total leverage (DTL)

 

You need to be able to define total leverage. You need to understand that total leverage refers to the use of both fixed operating costs and fixed financing costs to increase the effect that a change in sales revenue will have on the earnings per share (EPS) of a business entity.

 

Total leverage, therefore, reflects the total impact that the fixed costs in the operating and financial structure of a business entity can have on the value for shareholders.

 

To better understand the impact of the fixed operating costs and fixed financial costs, you need to study Example 13.12 and Table 13.7 in the prescribed textbook.

 

The extent to which a change in sales affects the EPS of a business entity is known as the degree of total leverage (DTL).

 

The DTL is a number which indicates the total leverage in a business entity and can be calculated as follows:

𝐃TL = % change in EPS/% change in sales revenue

 

Table 13.7 illustrates changes in the sales revenue, EBIT and the EPS of an entity. An increase in sales units of 30 000 – 20 000 = 10 000 (50%) results in an increase in EBIT by R800 000 – R500 000 = R300 000 (60%) and an increase in EPS by R5.40 – R1.20 = R4.20 (350%).

 

A 50% increase in sales (10 000/20 000) results in a 350% (R4.20/1.20) increase in EPS.

 

The degree of total leverage for the information in Table 13.7 is calculated as follows:

𝐃TL =% change in EPS/ % change in sales

𝐃TL = 350%/50%

𝐃TL = 7.0

A DTL = 7.0 means that for every R1.00 increase (decrease) in sales, the EPS of the business will increase (decrease) by R7.00.

You need to bear in mind that total leverage works both ways. While an increase in sales will lead to an increase in EPS, the opposite is equally true. A decrease in sales will lead to a decrease in EPS.

 

DTL AT BASE LEVEL

Example 13.14 and Formula 13.9 in the prescribed textbook explain and demonstrate how the DTL can be calculated given a specified level of sales in units.

The formula for DTL at a specified sales level is stated as follows:

DTL at base level EBIT =Q × (P – VC)/Q – (P – VC) – FC – 1 – (PD × (1 – 1/Tax rate) )

 

The degree of total leverage can also be calculated as follows:

DTL = DOL × DFL

 

THE FIRM’S CAPITAL STRUCTURE

You must be able to identify and discuss the types of capital found in organisations and use a statement of financial position to indicate the capital structure of an organisation.

Exclude the discussion of external assessment of capital structure (pages 511–520) for assignment and examination purposes. The key concepts that you must focus on are:

  • types of capital
  • optimal capital structure using NOPAT
  • cost functions

 

THE EBIT–EPS APPROACH TO THE CAPITAL STRUCTURE

Exclude section 13.3 for assignment and examination purposes.

 

CHOOSING THE OPTIMAL CAPITAL STRUCTURE

Exclude section 13.4 for assignment and examination purposes.

 

ADDITIONAL SOURCES TO ACCESS FMA 101 Topic 10

Access the following websites to broaden your understanding of capital structure in the context of financial management:

  • Capital structure flash cards: https://www.brainsc com/flashcards/topic-12-capital-structure-6499054/packs/10226428, accessed 9 March 2020.
  • Capital structure – debt and equity mix: http://www.mysmp.com/fundamental-analysis/capital-structure.html, accessed 8 March 2020.
  • Capital structure analysis: scribd.com/doc/24539818/Capital- Structure, accessed 8 March 2020.
  • The capital structure: https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-structure-overview/, accessed 9 March 2020.

 

 

FMA 101 SELF-ASSESSMENT EXERCISES

At the end of this chapter, there is a series of different self-test problems, warm- up exercises, problems and a more comprehensive case study. You should attempt to answer these questions, perform the calculations and use them to practise and re-enforce your learning and understanding. You may submit any of your answers to the lecturer for assessment and feedback.

SBS also shares copies of previous exam papers with you during the semester. The questions in these exam papers are very good examples of what you are expected to know and be able to do having studied and mastered the content of chapter 13 of the prescribed textbook and having followed the guidance provided in this topic.

 

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