Determining the financing mix
* Variability associated with expected revenue or income streams. Such variability may arise due to: * Choice of business line (business risk)
* Choice of an operating cost structure (operating risk) * Choice of Capital structure (financial risk)
a) Business Risk
* 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
b) 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.
c) 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.
II. Break-even Analysis
* Break-even analysis is used to determine the break-even quantity of firm’s output by examining the relationships among the firm’s cost structure, volume of output, and profit. * Break-even may be calculated in units or sales dollars. Break-even point indicates the point of sales or units at which EBIT is equal to zero.
Use of break-even model enables the financial manager:
1.To determine the quantity of output that must be sold to cover all operating
costs, as distinct from financial costs.
2.To calculate the EBIT that will be achieved at various output levels.
Elements of Break-even Model
* Break-even analysis requires information on the following: * Fixed Costs
* Variable Costs
* Total Revenue
* Total Volume
* Break-even analysis requires classification of costs into two categories: * Fixed costs or indirect costs
* Variable costs or direct costs
* Since all costs are variable in the long run, break-even analysis is a short-run concept.
Fixed or Indirect 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. Examples: Administrative salaries, Depreciation, Insurance, Lump sums spent on intermittent advertising programs, Property taxes & Rent.
Variable or Direct Costs
* Variable costs vary as output changes. Thus if production is increased by 5%, total variable costs will also increase by 5%. Examples:
* Direct labor
* Direct materials
* Energy costs (fuel, electricity, natural gas) associated with the production * Freight costs
* Sales commissions
* Total revenue is the total sales dollars
* Total Revenue = P Q
* P = selling price per unit
* Q = quantity sold
* 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
* EBIT = (Sales price per unit) (units sold)
– [(variable cost per unit) (units sold)
+ (total fixed cost)]
III. Operating Leverage
* 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.
* Thus % change in EBIT
= OL %...