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Debt 6%" 1.8%
0.3
Retained earnings 13%b
0.7 9.1
k, = 10.9%
"kd= k,(l  t ) = 10%(1  0.4) = 6%
With $300,000$600,000:
Source of Capital Weight AfterTax Cost Weighted Cost
Debt 0.3 6Yo 1.80%
External equity 0.7 9.73
13.9%"
k, = 11.53%
304 COST OF CAPITAL [CHAP. 10
L
20
c. 16
v n
New financing (thousands of dollan)
Above $6OO,OOO:
AfterTax Cost
Source of Capital Weight Weighted Cost
0.3 2.52%
Debt 8.4%"
13.9% 9.73
External equity 0.7
k, = 12.25%
14%(1  0.4) = 8.4%
= k,(l t ) =
'kd
The MCC and 10s schedules are shown in Fig. 103.
(c)
(d) The company should select projects A, D, and C for a total optimal capital budget of $500,000.
Chapter 11
Leverage and Capital Structure
11.1 LEVERAGE DEFINED
Leverage is that portion of the fixed costs which represents a risk to the firm. Operating leverage,
a measure of operating risk, refers to the fixed operating costs found in the firmâ€™s income statement.
Financial leverage, a measure of financial risk, refers to financing a portion of the firmâ€™s assets, bearing
fixed financing charges in hopes of increasing the return to the common stockholders. The higher the
financial leverage, the higher the financial risk, and the higher the cost of capital. Cost of capital rises
because it costs more to raise funds for a risky business.
1 . BREAKEVEN POINT, OPERATING LEVERAGE, AND FINANCIAL LEVERAGE
12
A discussion of breakeven analysis, broadly known as costlvolumdprofit analysis, is necessary for
understanding the nature and importance of operating leverage.
BreakEven Analysis
The breakeven point is the level of sales at which no profit or loss results. To determine the
breakeven point, the costs must be divided into (1) variable costs which are costs that vary in direct
proportion to a change in volume, and (2) #ed costs, which are costs that are constant regardless of
volume.
The breakeven point can be found easily by setting sales just equal to the total of the variable costs
plus the fixed costs:
S = Sales ($)
Let
X = Sales volume in units
P = Selling price per unit
V = Unit variable cost
VC = Variable operating costs
FC = Fixed operating costs
Then
+ FC
S = VC
PX=VX+FC
(P  V)X = FC
or
Breakeven sales  fixed operating costs

unit selling price unit variable cost
in units
EXAMPLE 11.1 The Wayne Company manufactures and sells doors to home builders. The doors are sold for
$25 each. Variable costs are $15 per door, and fixed operating costs total $50,000. The companyâ€™s breakeven
point is:
x==
FC = 5,000 doors
PV $25$15
Therefore, the company must sell 5,000 doors to break even.
305
306 LEVERAGE AND CAPITAL STRUCTURE [CHAP. 11
Cash BreakEven Point
If a firm has a minimum of available cash or the opportunity cost of holding excess cash is high,
management may want to know the volume of sales that will cover all cash expenses during a period.
This is known as the cash breakeven point.
Not all fixed operating costs involve cash payments. For example, depreciation expenses are noncash
charges. To find the cash breakeven point, the noncash charges must be subtracted from total fixed
operating costs. Therefore, the cash breakeven point is lower than the usual breakeven point. The
formula is:
X = FCd
Pv
where d is depreciation expenses.
EXAMPLE 11.2 Assume from Example 11.1that the total fixed operating costs of $50,000 include depreciation
in the amount of $2,000. Then the Wayne Company cash breakeven point is:
The company has to sell 4,800 doors to cover only the fixed costs involving cash payments of $48,000 and to
break even.
Operating Leverage
Operating leverage is a measure of operating risk and arises from fixed operating costs. A simple
indication of operating leverage is the effect that a change in sales has on earnings. The formula is:
(P  V ) X
% change in EBIT 

Operating leverage at a given level of sales ( X ) =
(P  V)X  FC
YOchange in sales
where
EBIT = earnings before interest and taxes
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