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Corporate
Finance FIN 622
VU
Lesson
13
OPERATING
LEVERAGE & CAPITAL
RATIONING
The
following topics will be
discussed in this lecture.
Economic
Break Even
Degree
of Operating Leverage
Capital
Rationing
Hard
Rationing
Soft
Rationing
Single
Period Rationing
Multi
period linear programming with only
two variables
Limitation
of Linear Programming / Criticism
ECONOMIC
BREAK EVEN:
The
difference between the accounting and
economic break even is a
cost factor known as
opportunity cost
of
capital. In accounting break
even we calculate the accounting
earnings first and then
deduct all the costs
from
earnings to reach at break
even except the opportunity
cost of capital that is
invested in the project.
According
to Economic Value Added (EVA)
concept, a firm creates
value by earning returns of
invested
capital
greater than its cost of
capital. Basically, EVA is the economic
profit a firm earns after
all capital
costs
are deducted. More precisely
stated, it is firm's net operating profit
after tax less the cost of
capital
charge
for the capital
employed.
A firm
can create value for
its investors either by investing in new
assets or it can return cash
to investors
who
will invest this money for
themselves by trading in the stock
market. A firm that earns
more than the
cost
of capital is better off since it is
providing investors with better
returns than they can earn
for
themselves
on stand alone basis.
Economic
break even suggests that
when you deduct other
cost from accounting
earnings you should
also
deduct
the cost of capital employed. A
project having a positive EVA adds
value to firm and a
negative
EVA
reduces the firm's
value.
DEGREE
OF OPERATING LEVERAGE
A
measurement of the degree to which a
firm or project incurs a
combination of fixed and variable
costs.
1. A
business that makes few
sales, with each sale
providing a very high gross
margin, is said to be
highly
leveraged.
A business that makes many
sales, with each sale
contributing a very slight margin, is
said to
be
less leveraged. As the volume of
sales in a business increases,
each new sale contributes
less to
fixed
costs and more to
profitability.
2. A
business that has a higher
proportion of fixed costs
and a lower proportion of variable
costs is said
to
have used more operating
leverage. Those businesses
with lower fixed costs
and higher variable
costs
are said to employ less operating
leverage.
The
higher the degree of operating leverage the
greater the potential danger
from forecasting risk. That
is, if
a relatively
small error is made in
forecasting sales, it can be magnified
into large errors in cash
flow
projections.
The opposite is true for businesses
that are less leveraged. A
business that sells millions
of
products
a year, with each
contributing slightly to paying for
fixed costs, is not as
dependent on each
individual
sale.
For
example, convenience stores
are significantly less leveraged
than high-end car
dealerships.
Capital
Rationing
Many
companies specify an overall
limit on the total budget for
capital spending. There is no
conceptual
justification
for such budget ceiling, because
all projects that enhance
long run profitability should
be
accepted.
The
factors for putting
limit:
· Net
present values or IRR may
strongly influence the overall budget amount
· Top
management's philosophy toward
capital spending.
· Same
managers are highly growth
minded whereas others are
not.
· The
outlook for future investment
opportunities that may not
be feasible if extensive current
commitments
are undertake.
· The
funds provided by the current operations less
dividends.
43
Corporate
Finance FIN 622
VU
·
The
feasibility of acquiring additional
capital through borrowing or
sale of additional stock.
Lead-
time
and costs of financial market
transactions can influence
spending.
· Period of
impending change in management
personnel, when the status
quo is maintained.
· Management
attitudes toward not.
Capital
Rationing occurs when a
company has more amounts of
capital budgeting projects with
positive net
present
values than it has money to invest in
them. Therefore, some projects
that should be accepted
are
excluded
because financial capital is
limited.
This is
known as artificial constraint because
the management may dictate the amount to
be invested for
project
purposes.
It is
also the artificial constraints
because the amount is not based on the
product marginal analysis in
which
the
return for each proposal is
related to the cost of capital
and projects with net
present values are
accepted.
A
company may adopt a posture
of capital rationing because it is
fearful of too much growth
or hesitant to
use
external sources of financing.
Reasons
for Capital
Rationing:
There
are basically two types of
reasons of capital
rationing.
· External
Reasons
These
arise when a firm is unable to
borrow from the outside. For
example if the firm is under
financial
distress, tight credit conditions, firm
has a new unproven
product.
Borrowing
limits are imposed by banks
particularly in relation to smaller firms
and individuals.
· Internal
Reasons
Private owned
company: Owners might decide
that expansion is a trouble
not worth taking. For
example
there may that management
fear to lose their control
in the company.
o Divisional
Constraints: Upper management
allocates a fixed amount for
each division as
part
of the overall corporate strategy. This
arises from a point of view
of a department,
cost
centre or wholly owned subsidiary, the
budgetary constraints determined by
senior
management
or head office.
o Human
Resource Limitations: Company
does not have enough middle
management to
manage
the new expansions
o Dilution:
For example, there may be a
reluctance to issue further equity by
management
fearful
of losing control of the company.
o Debt
Constraints: Earlier debt
issues might prohibit the
increase in the firm's debt
beyond
a
certain level, as stipulated in previous debt
contracts. For example bondholders
requiring
in the
bond contract, that they
would accept a maximum
Debt-to-Asset ratio = 40%.
Capital
Rationing could be said to signal a
managerial failure to convince suppliers
of funds of the value of
the
available projects. Although
there may be something in this
argument, in practice it is not a
well-
informed
judgment. Furthermore, even if there were
no limits on the total amounts of
available finance, in
reality the
price may vary with the size
as well as the term of the loan.
HARD
CAPITAL RATIONING:
This
arises when constraints are
externally determined. This will
not occur under perfect
market.
If
share prices are depressed
or market is bearish, raising
capital is very difficult.
Restriction on
lending by Banks.
High
interest rate
High
cost associated with
issuance of share / debt
instrument.
SOFT
CAPITAL RATIONING:
This
arises with internal,
management-imposed limits on investment expenditure.
The factors leading
to
soft
rationing are as under:
Management
is reluctant to issue new share
because of the fear of outsider taking
control of
company.
Dilution
of EPS
Increased
interest payments in case of
debt financing.
Company's
will to maintain limited investment level
that can be financed thru
retained
earnings.
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