Break-even Analysis The break-even level or break-even point (BEP) represents the sales amountin either unit or revenue

termsthat is required to cover total costs (both fixed and variable). Profit at break-even is zero. Breakeven is only possible if a firms prices are higher than its variable costs per unit. If so, then each unit of the product sold will generate some contribution toward covering fixed costs. In economics & business, specifically cost accounting, the break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even." A profit or a loss has not been made, although opportunity costs have been "paid," and capital has received the risk-adjusted, expected return. In short, all costs that needs to be paid are paid by the firm but the profit is equal to 0. For example, if a business sells fewer than 200 tables each month, it will make a loss; if it sells more, it will make a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could: 1. Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs) 2. Try to reduce variable costs (the price it pays for the tables by finding a new supplier) 3. Increase the selling price of their tables. Any of these would reduce the break-even point. In other words, the business would not need to sell so many tables to make sure it could pay its fixed costs.

To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging. The break-even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break-even quantity at each selling price can be read off the horizontal axis and the break-even price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis. Algebraic Approach Using the following variables, we can recast the operating portion of the firms income statement given in Table 13.1 into the algebraic representation shown in Table 13.2. VC = variable operating cost per unit FC = fixed operating cost per period Q = sales quantity in units P = sale price per unit

Rewriting the algebraic calculations in Table 13.2 as a formula for earnings before interest and taxes yields Equation 13.1: The purpose of break-even analysis is to provide a rough indicator of the earnings impact of a marketing activity. The break-even point is one of the simplest yet least used analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs, and profits. For example, expressing break-even sales as a percentage of actual sales can give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). The break-even point is a special case of Target Income Sales, where Target Income is 0 (breaking even). This is very important for financial analysis. By inserting different prices into the formula, you will obtain a number of break-even points, one for each possible price charged. If the firm changes the selling price for its product, from $2 to $2.30, in the example above, then it would have to sell only 1000/(2.3 - 0.6)= 589 units to break even, rather than 715.

Simplifying Equation 13.1 yields: EBIT = Q x (P - VC) FC (13.2)

As noted above, the operating breakeven point is the level of sales at which all fixed and variable operating costs are coveredthe level at which EBIT equals $0. Setting EBIT equal to $0 and solving Equation 13.2 for Q yields:

Q is the firms operating breakeven point. Contribution Margin Approach The contribution margin approach to calculate the break-even point (i.e. the point of zero profit or loss) is based on the CVP analysis concepts known as contribution margin and contribution margin ratio. Contribution margin is the difference between sales and variable costs. When calculated for a single unit, it is called unit contribution margin. Contribution margin ratio is the ratio of contribution margin to sales. In this method simple formulas are derived from the CVP analysis equation by rearranging the equation and then replacing certain parts with Contribution Margin formulas. Break-even Sales Units = x = FC ( P VC ) Since unit contribution margin (Unit CM) is equal to unit sale price (p) less unit variable cost (v), So, Unit CM = P VC Therefore,

Break-even Sales Units = FC Unit CM Break-even point for Multiple Products Some company sells more than one product. As discussed from the past lesson, calculations for multiple product break-even points use the same equation. Such that we need to compute first the weighted average contribution margin per unit. Sales mix is the proportion in which two or more products are sold. Example below shows how the break-even point for multiple products is computed. Apple Pie Apple Sauce Price $12 $6 Variable Cost $4 $2 Sales Mix Fixed Cost 1. 3 $26,000 7

First, get the contribution margin per product (CM= Price Variable Cost). Well get $8 for apple pie and $4 for apple sauce. 2. Get the total contribution margin. Total contribution margin= CM x Sales Mix. Well get 24 for apple pie and 28 for apple sauce. 3. Get the weighted average CM per unit. Divide total contribution margin (24 + 28= 52) by total number of products sold (3 + 7= 10). 52/10= $5.20 4. Compute the Break-even point for multiple products using the equation BEP= FC/CM. BEP= $26000/$5.20= 5000 units of apple pie and apple sauce. To get how many units of apple pie and apple sauce are in the breakeven point, multiply the break-even point by the sales mix percentage of each product. For apple pie, 5000 x 30%= 1500. For apple sauce= 5000 x 70%= 3500. So we have 1500 apple pies and 3500 jars of apple sauce at the break-even point. To get product sales in dollars, multiply the unit sales to price per unit of the product. For apple pie, 1500 x $12= $18,000. For apple sauce, 3500 x $6= $21,000. To check if its in the break-even point, equate CM and the fixed cost. Since the total of contribution margin of the products is $26,000($12,000 + $14,000) and our fixed cost is also $26,000, there is break even.

Operating Leverage Operating leverage is concerned with the relationship between the firms sales revenue and its earnings before interest and taxes (EBIT) or operating profits. When costs of operations (such as cost of goods sold and operating expenses) are largely fixed, small changes in revenue will lead to much larger changes in EBIT. For example :

Leverage Leverage refers to the effects that fixed costs have on the returns that shareholders earn. By fixed costs we mean costs that do not rise and fall with changes in a firms sales. Firms have to pay these fixed costs whether business conditions are good or bad. These fixed costs may be operating costs, such as the costs incurred by purchasing and operating plant and equipment, or they may be financial costs, such as the fixed costs of making debt payments. Generally, leverage magnifies both returns and risks. A firm with more leverage may earn higher returns on average than a firm with less leverage, but the returns on the more leveraged firm will also be more volatile. Many business risks are out of the control of managers, but not the risks associated with leverage. Managers can limit the impact of leverage by adopting strategies that rely more heavily on variable costs than on fixed costs. For example, a basic choice that many firms confront is whether to make their own products or to outsource manufacturing to another firm. A company that does its own manufacturing may invest billions in factories around the world. These factories generate costs whether they are running or not. In contrast, a company that outsources production can completely eliminate its manufacturing costs simply by not placing orders. Costs for a firm like this are more variable and will generally rise and fall as demand warrants.

Using the data for Cheryls Posters (sale price, P $10 per unit; variable operating cost, VC $5 per unit; fixed operating cost, FC $2,500), Figure 13.2 presents the operating breakeven graph originally shown in Figure 13.1. The additional notations on the graph indicate that as the firms sales increase from 1,000 to 1,500 units (Q1 to Q2), its EBIT increases from $2,500 to $5,000 (EBIT1 to EBIT2). In other words, a 50% increase in sales (1,000 to 1,500 units) results in a 100% increase in EBIT ($2,500 to $5,000). Table 13.4 includes the data for Figure 13.2 as well as relevant data for a 500-unit sales level. We can illustrate two cases using the 1,000-unit sales level as a reference point. Case 1 A 50% increase in sales (from 1,000 to 1,500 units) results in a 100% increase in earnings before interest and taxes (from $2,500 to $5,000). Case 2 A 50% decrease in sales (from 1,000 to 500 units) results in a 100% decrease in earnings before interest and taxes (from $2,500 to $0).

An increase in sales results in a more-than-proportional increase in EBIT; a decrease in sales results in a more-than-proportional decrease in EBIT. Measuring the Degree of Operating Leverage (DOL) The degree of operating leverage (DOL) is a numerical measure of the firms operating leverage. It can be derived using the following equation:

coupon rate of interest and an issue of 600 shares of $4 (annual dividend per share) preferred stock outstanding. It also has 1,000 shares of common stock outstanding. The annual interest on the bond issue is $2,000 (0.10 $20,000). The annual dividends on the preferred stock are $2,400 ($4.00/share 600 shares). Table 13.6 presents the earnings per share (EPS) corresponding to levels of EBIT of $6,000, $10,000, and $14,000, assuming that the firm is in the 40% tax bracket. The table illustrates two situations: Case 1 A 40% increase in EBIT (from $10,000 to $14,000) results in a 100% increase in earnings per share (from $2.40 to $4.80). Case 2 A 40% decrease in EBIT (from $10,000 to $6,000) results in a 100% decrease in earnings per share (from $2.40 to $0).

Whenever the percentage change in EBIT resulting from a given percentage change in sales is greater than the percentage change in sales, operating leverage exists. This means that as long as DOL is greater than 1, there is operating leverage. For example: Applying Equation 13.4 to cases 1 and 2 in Table 13.4 yields the following results:

Because the result is greater than 1, operating leverage exists. For a given base level of sales, the higher the value resulting from applying Equation 13.4, the greater the degrees of operating leverage. A more direct formula for calculating the degree of operating leverage at a base sales level, Q, is:

For example: Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500 into equation above yields the following result:

The effect of financial leverage is such that an increase in the firms EBIT results in a more-than-proportional increase in the firms earnings per share, whereas a decrease in the firms EBIT results in a more-thanproportional decrease in EPS. Measuring the Degree of Financial Leverage (DFL) The degree of financial leverage (DFL) is a numerical measure of the firms financial leverage. Computing it is much like computing the degree of operating leverage. The following equation presents one approach for obtaining the DFL.

Financial Leverage Financial leverage is concerned with the relationship between the firms EBIT and its common stock earnings per share (EPS). On the income statement, you can see that the deductions taken from EBIT to get to EPS include interest, taxes, and preferred dividends. Taxes are clearly variable, rising and falling with the firms profits, but interest expense and preferred dividends are usually fixed. When these fixed items are large (that is, when the firm has a lot of financial leverage), small changes in EBIT produce larger changes in EPS.

Whenever the percentage change in EPS resulting from a given percentage change in EBIT is greater than the percentage change in EBIT, financial leverage exists. This means that whenever DFL is greater than 1, there is financial leverage. For example: Applying the above equation.

In both cases, the quotient is greater than 1, so financial leverage exists. The higher this value is, the greater the degree of financial leverage. For example: Chen Foods, a small Asian food company, expects EBIT of $10,000 in the current year. It has a $20,000 bond with a 10% (annual) Situation:

Shanta and Ravi Shandra, a married couple with no children, wish to assess the impact of additional long-term borrowing on their degree of financial leverage (DFL). The Shandras currently have $4,200 available after meeting all of their monthly living (operating) expenses, before making monthly loan payments. They currently have monthly loan payment obligations of $1,700 and are considering the purchase of a new car, which would result in a $500 per month increase (to $2,200) in their total monthly loan payments. Because a large portion of Ravis monthly income represents commissions, the Shandras feel that the $4,200 per month currently available for making loan payments could vary by 20% above or below that amount. To assess the potential impact of the additional borrowing on their financial leverage, the Shandras calculate their DFL for both their current ($1,700) and proposed ($2,200) loan payments as follows, using the currently available $4,200 as a base and a 20% change.

of $10,000, interest of $20,000, and preferred stock dividends of $12,000. The firm is in the 40% tax bracket and has 5,000 shares of common stock outstanding. Table 12.7 on the following slide summarizes these figures.

Total Leverage: Measuring the Degree of Total Leverage

Based on their calculations, the amount the Shandras will have available after loan payments with their current debt changes by 1.68% for every 1% change in the amount they will have available for making the loan payments. This is considerably less responsiveand therefore less riskythan the 2.10% change in the amount available after loan payments for each 1% change in the amount available for making loan payments with the proposed additional $500 in monthly debt payments. Although it appears that the Shandras can afford the additional loan payments, they must decide if, given the variability of Ravis income, they feel comfortable with the increased financial leverage and risk. A more direct formula for calculating the degree of financial leverage at a base level of EBIT is given by Equation 13.7, where the notation from Table 13.6 is used. Note that in the denominator the term 1/(1 - T) converts the after-tax preferred stock dividend to a before-tax amount for consistency with the other terms in the equation.

Applying this equation to the data Table 12.7 yields: Degree of Total Leverage (DTL)

A more direct formula for calculating DTL at a base level of Sales, Q, is shown below.

Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I = $20,000, PD = $12,000, and the tax rate, T = 40% yields the following result:

For example: Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and the tax rate (T = 0.40) into Equation 13.7 yields the following result:

Total Leverage Total leverage results from the combined effect of using fixed costs, both operating and financial, to magnify the effect of changes in sales on the firms earnings per share. Total leverage can therefore be viewed as the total impact of the fixed costs in the firms operating and financial structure. Example: Cables Inc., a computer cable manufacturer, expects sales of 20,000 units at $5 per unit in the coming year and must meet the following obligations: variable operating costs of $2 per unit, fixed operating costs

Total Leverage: The Relationship of Operating, Financial and Total Leverage The relationship between the DTL, DOL, and DFL is illustrated in the following equation: DTL = DOL x DFL Applying this to our previous example we get: DTL = 1.2 X 5.0 = 6.0 The Firms Capital Structure Capital structure is one of the most complex areas of financial decision making due to its interrelationship with other financial decision variables. Poor capital structure decisions can result in a high cost of capital, thereby lowering project NPVs and making them more unacceptable. Effective decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects, thereby increasing the value of the firm.

When developing the firms capital structure, the financial manager must accept as given these levels of EBIT and their associated probabilities. These EBIT data effectively reflect a certain level of business risk that captures the firms operating leverage, sales revenue variability, and cost predictability Financial Risk Capital Structure Theory According to finance theory, firms possess a target capital structure that will minimize its cost of capital. Unfortunately, theory cannot yet provide financial managers with a specific methodology to help them determine what their firms optimal capital structure might be. Theoretically, however, a firms optimal capital structure will just balance the benefits of debt financing against its costs. The major benefit of debt financing is the tax shield provided by the federal government regarding interest payments. The costs of debt financing result from: the increased probability of bankruptcy caused by debt obligations, the agency costs resulting from lenders monitoring the firms actions, and the costs associated with the firms managers having more information about the firms prospects than do investors (asymmetric information). Capital Structure Theory: Tax Benefits Allowing companies to deduct interest payments when computing taxable income lowers the amount of corporate taxes. This in turn increases firm cash flows and makes more cash available to investors. In essence, the government is subsidizing the cost of debt financing relative to equity financing. Capital Structure Theory: Probability of Bankruptcy The probability that debt obligations will lead to bankruptcy depends on the level of a companys business risk and financial risk. Business risk is the risk to the firm of being unable to cover operating costs. In general, the higher the firms fixed costs relative to variable costs, the greater the firms operating leverage and business risk. Business risk is also affected by revenue and cost stability. The firms capital structurethe mix between debt versus equitydirectly impacts financial leverage. Financial leverage measures the extent to which a firm employs fixed cost financing sources such as debt and preferred stock. The greater a firms financial leverage, the greater will be its financial riskthe risk of being unable to meet its fixed interest and preferred stock dividends. Business Risk

Let us assume that (1) the firm has no current liabilities, (2) its capital structure currently contains all equity, and (3) the total amount of capital remains constant at $500,000, the mix of debt and equity associated with various debt ratios would be as shown in Table 12.10. Table 12.10 Capital Structures Associated with Alternative Debt Ratios for Cooke Company

Table 12.11 Level of Debt, Interest Rate, and Dollar Amount of Annual Interest Associated with Cooke Companys Alternative Capital Structures

Table 12.12 Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company (cont.)

Example: Cooke Company, a soft drink manufacturer, is preparing to make a capital structure decision. It has obtained estimates of sales and EBIT from its forecasting group as show in Table 12.9. Table 12.9 Sales and Associated EBIT Calculations for Cooke Company ($000)

Figure 12.3 Probability Distributions

Table 12.12 Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company (cont.) Figure 12.4 Expected EPS and Coefficient of Variation of EPS

Table 12.12 Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company

Table 12.13 Expected EPS, Standard Deviation, and Coefficient of Variation for Alternative Capital Structures for Cooke Company

Capital Structure Theory: Agency Costs Imposed by Lenders When a firm borrows funds by issuing debt, the interest rate charged by lenders is based on the lenders assessment of the risk of the firms investments. After obtaining the loan, the firms stockholders and/or managers could use the funds to invest in riskier assets. If these high risk investments pay off, the stockholders benefit but the firms bondholders are locked in and are unable to share in this success. To avoid this, lenders impose various monitoring costs on the firm. Examples would of these monitoring costs would: include raising the rate on future debt issues, denying future loan requests, imposing restrictive bond provisions. Capital Structure Theory: Asymmetric Information Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors. Asymmetric information can impact the firms capital structure as follows: Suppose management has identified an extremely lucrative investment opportunity and needs to raise capital. Based on this opportunity, management believes its stock is undervalued since the investors have no information about the investment. In this case, management will raise the funds using debt since they believe/know the stock is undervalued (underpriced) given this information. In this case, the use of debt is viewed as a positive signal to investors regarding the firms prospects. On the other hand, if the outlook for the firm is poor, management will issue equity instead since they believe/know that the price of the firms stock is overvalued (overpriced). Issuing equity is therefore generally thought of as a negative signal.

The Optimal Capital Structure In general, it is believed that the market value of a company is maximized when the cost of capital (the firms discount rate) is minimized. The value of the firm can be defined algebraically as follows:

Figure 12.6 EBITEPS Approach

Figure 12.5 Cost Functions and Value

EPS-EBIT Approach to Capital Structure The EPS-EBIT approach to capital structure involves selecting the capital structure that maximizes EPS over the expected range of EBIT. Using this approach, the emphasis is on maximizing the owners returns (EPS). A major shortcoming of this approach is the fact that earnings are only one of the determinants of shareholder wealth maximization. This method does not explicitly consider the impact of risk. Example EBIT-EPS coordinates can be found by assuming specific EBIT values and calculating the EPS associated with them. Such calculations for three capital structuresdebt ratios of 0%, 30%, and 60%for Cooke Company were presented earlier in Table 12.2. For EBIT values of $100,000 and $200,000, the associated EPS values calculated are summarized in the table with Figure 12.6.

Basic Shortcoming of EPS-EBIT Analysis Although EPS maximization is generally good for the firms shareholders, the basic shortcoming of this method is that it does not necessary maximize shareholder wealth because it fails to consider risk. If shareholders did not require risk premiums (additional return) as the firm increased its use of debt, a strategy focusing on EPS maximization would work. Unfortunately, this is not the case. Choosing the Optimal Capital Structure The following discussion will attempt to create a framework for making capital budgeting decisions that maximizes shareholder wealthi.e., considers both risk and return. Perhaps the best way to demonstrate this is through the following example: Cooke Company, using as risk measures the coefficients of variation of EPS associated with each of seven alternative capital structures, estimated the associated returns as shown in Table 12.14

By substituting the level of EPS and the associated required return into Equation 12.12, we can estimate the per share value of the firm, P0.

Table 12.15 Calculation of Share Value Estimates Associated with Alternative Capital Structures for Cooke Company

Table 12.16 Important Factors to Consider in Making Capital Structure Decisions

Figure 12.7 Estimating Value