Leverage
- uses fixed costs
- amplifies risk and potential return
Operating leverage
- Fixed (salary) = Total cost is “independent” of sales
- Variable(sales) = Total cost is “dependent” on sales
DOL( Degree of operating leverage)
DOL = % change in EBIT / % change in sales
EBIT = earnings before income tax
Fixed Leverage
Fixed (debt) = Interest expense is “independent” of profit
Variable (equity) = Dividends “dependent” of profit
DFL( Degree of financial leverage)
DFL = % change in EPS(earnings per share) / % change in EBIT
Combined Total Leverage
do not add them together instead multiply, DOL x DFL = Combined Total leverage
WACC and optimal capital structure
- the optimal capital structure is the one with the lowest WACC(weighted average cost of capital)
FCFF/WACC
WACC = cost of equity multiplied by the percentage equity in capital structure + Weighted average cost of debt* multiplied by the percentage debt in capital structure
- MAKE sure it is AFTER tax considerations
Weighted-average cost of debt
- pre-tax only step 1
- step 2 take YTM “market rate” x (1 -tr) = after tax cost(relevant)
weighted average interest rate ( or YTM “market rate” = effective annual interest payments / debt cash available
( outflow / net inflow)
Cost of long-term debt
-Debt is typically the cheapest form of capital(compared to equity), since the government makes interest payments tax deductible, and it is less risky for the lenders since they get paid back in bankruptcy before the stockholders
To get cost of long term debt take the debt x (1 - tr). i.e if your debt is $100,000 and the tax rate is 30% since the debt is tax deductible your cost of detb is only $70,000
Cost of Preferred stock
- is GREATER than the cost of debt, since dividends are not tax deductible and the stockholders assume more risk than lenders so it costs more
Outflow(dividends) / net inflow = Cost
Cost of retained earnings(common equity)
- Greater cost than debt and preferred stock, since common stockholders assume the greatest level of risk in the event of a bankruptcy
Risk premium
- if beta = to 1 the company is equally as risky as the stock market
- if beta is greater > than 1 the company is riskier than the stock market
- and if beta is less < than 1 the company is safer than the stock market
Cost of retained earnings formula(CAPM)
rfr(risk free rate)
mr(market rate)
b = beta
= rfr +[ b x (mr - rfr)]
Discounted cash flow formula(cost of retained earnings DCF)
Div1 = forecasted dividend in future
= Div0(today’s dividend) x ( 1 + g)
P = price of stock
g = growth
DCF=[Div1 / P] + g
Bond Yield Plus Risk Premium(cost of retained earnings BYRP)
BYRP = Pre-tax YTM + Risk premium
ROI (return on investment)
ROI =Income / Investment capital( or “avg. assets) (or Avg PPE + Avg WC(working capital)
OR
ROI = profit margin* x Investment turnover**
Profit margin = Income / sales
Investment turnover** = Sales / invested capital
ROA ( return on assets)
ROA = Net income / total average assets
Residual income EVA( economic value added)
Residual income is the income earned beyond what was desired
Residual income = Net income - required return in $*
*required return in $ = hurdle rate x net book value
EVA( economic value added)
- same exact formula as residual income, except the hurdle rate for required rate of return MUST be that companies WACC(weighted average cost of capital)
Debt-to-capital ratio
- Measure of financial leverage, i.e risk
= Total debt / Total Capital(= Debt + Equity)
Debt-to-Asset ratio
= total debt / total assets
Debt-to-equity ratio
Total debt / total shareholders equity
Working Capital
Current Assets - Current Liabilities
Quick Ratio
Cash + Marketable securities + Receivables / Current Liabilities
