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101: Financial Leverage
By Gregg Schoenberg Monday, March 25, 2013

In a Operating Leverage post we demonstrated that increasing a firm’s operating leverage, by replacing variable costs with fixed costs, could lead to greater profits; but that it also increased the firm’s risk level. This week, as promised, we’ll take a look at financial leverage and see how the mix of debt and equity financing affects risk and return.

As you may recall from our piece about capital structure, all of the money that you raise for your firm will come in the form of either debt or equity. If you are using any amount of debt financing (i.e. borrowing money) then you are employing financial leverage. If all the money you’ve raised is in the form of equity, then your company is not using any financial leverage.

Financial leverage, like operating leverage, increases a firm’s chance to raise its level of profits, but also leads to greater risk. So when it comes time to raise funds, how do we assess whether to use debt or equity? We can begin with a simple example that demonstrates how the choice between debt and equity affects the owners’ return on their investment (known in the financial parlance as the return on equity or ROE).

For this example we’ll assume that a company needs to raise $100,000, that it can borrow up to $40,000 at a 5% interest rate, and that it pays corporate income taxes at a 40% rate.

 

Scenario 1: 100% Equity Financing

       
Balance Sheet      
Assets   Liabilities and Equity  
Cash

 $100,000

Equity

 $100,000

       
Income Statement      
       
Sales

 $100,000

   
Expenses

 $80,000

   
Earnings before interest and taxes (EBIT)

 $20,000

   
Taxes (40% Rate)

 $8,000

   
Net Earnings

 $12,000

   
       
Return on Equity

12%

   
       

Scenario 2: 60% Equity Financing, 40% Debt Financing @ 5% Interest Rate

       
Balance Sheet      
Assets   Liabilities and Equity  
Cash

 $100,000

Debt

 $40,000

    Equity

 $60,000

Income Statement      
       
Sales

 $100,000

   
Expenses

 $80,000

   
Earnings before interest and taxes (EBIT)

 $20,000

   
Interest Expense

 $2,000

   
Taxable Income

 $18,000

   
Taxes (40% Rate)

 $7,200

   
Net Earnings

 $10,800

   
       
Return on Equity

18%

   

 

In Scenario 1 the company elects not to issue any debt and winds up with net earnings of $12,000 for a return on equity of 12%. In Scenario 2 this same company elects to raise 40% of its required funds ($40,000) with debt and winds up with lower net earnings of $10,800 but a significantly higher return on equity of 18%. What happened? How does issuing debt and thereby reducing earnings lead to a higher return on equity?

The answer lies in the fact that under Scenario 2 the company’s owners only invested $60,000 of their own money, instead of the $100,000 invested under Scenario 1, and were able to earn $10,800 or 18% on that investment. So, this demonstrates one of the two key points we made earlier about financial leverage: that its use can increase a firm’s level of profitability.

And there are actually two important factors at work driving this increased ROE. First is that the firm was able to borrow money at 5% and to earn more than that through its core business activities. Second, and perhaps more importantly, is the fact that the company doesn’t have to pay taxes on its interest expenses. It is largely because of this tax advantage that so many companies choose to raise a portion of their financing via debt.

But, as in all cases involving risk and return, the increased returns associated with financial leverage also carry increased risks. Just as financial leverage can increase owners’ return on equity during the good times; it can lead to dramatic, and potentially fatal, reductions in ROE during difficult times. If a firm takes on too much debt in an effort to jack up ROE and things take a turn for the worse, it may be forced to declare bankruptcy if it can’t afford to pay back that debt.

So when it comes time to choose between debt and equity for your company, remember to analyze carefully the potential effects on both your return and your risk, and to consult with accounting or finance professionals before making any final decisions.

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Trade Name vs. Trademark
By Andrew Millman Tuesday, March 19, 2013

What’s a Trade Name? What’s a Trademark?  Far too often the line between the two is skewed.  Here’s some general information that should help clarify the differences between the two.

Simply put, a “trade name” is basically the name that you’ve used to identify your company.  It offers no legal protection or limitless rights for the use of that name, it is just the name.

A “trademark” is the process of registering the name with the United States Patent and Trademark Office to protect your brand name, product name, logo, catch phrase, etc. from someone else being able to infringe upon it.  In many cases, the name you trademark can be your trade name, but it does not necessarily have to be.  On the flip side, you may be able to give your company a trade name that is not available to be trademarked.

For more information on the trademark process go to http://www.uspto.gov/

Often times we will find that the trade name will be available in one State and not another.  In which case, you may choose to operate under a “fictitious name”. This is known as a “DBA” or “doing business as” name. Typically, a DBA is set up locally where you plan to physically operate.  Keep in mind that a DBA does not afford the same legal protections as incorporating.

For further information on the DBA read Do I Need A DBA?

In many cases, before setting up the DBA, you may be required to register your company as a foreign entity in any State in which you plan to operate other than its State of Incorporation.  The foreign qualification process is often necessary if you plan to conduct business, hire employees, hold assets, or do banking in a State other than the one where the company was formed.

If you have questions about the difference between a trade name and a trademark, just give us a call at 800-345-2677 and we’ll be happy to help discuss it further.

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101: Operating Leverage
By Gregg Schoenberg Monday, March 18, 2013

In our recent posts on breakeven analysis and capital structure we touched upon a very important concept that all business owners should understand: leverage. Employing fixed costs rather than variable costs increases a firm’s operating leverage, while issuing debt rather than equity increases financial leverage. Both types of leverage can lead to greater profits, but both also increase risk. This week we’ll explore the effects of operating leverage, and next week we’ll take a look at financial leverage.

Business owners often have to choose between investing in fixed costs or variable costs. For example, a purchasing manager may need to determine whether it makes sense to invest a substantial amount of money in a new computer system (a fixed cost) that can reduce the amount of time its hourly employees spend producing a certain product (a variable cost). If the purchasing manager chooses to replace variable costs with fixed costs by buying the new system then he is increasing the firm’s operating leverage.

We know that increasing operating leverage brings the potential for greater profits, but it also entails taking on more risk. So how does the purchasing manager make his decision? We can start to answer this question by looking at a simple table that examines the relationship between fixed costs, variable costs, and profits.

Scenario 1: Fixed Costs = $10,000, Variable Costs = $10.00

Price Quantity Total Fixed Variable Total Total Profit/
Per Unit Sold Revenue Costs Costs Per Unit Variable Cost Costs Loss

 $20.00

0

 $-

 $10,000.00

 $10.00

 $-

 $10,000.00

 $(10,000.00)

 $20.00

250

 $5,000.00

 $10,000.00

 $10.00

 $2,500.00

 $12,500.00

 $(7,500.00)

 $20.00

500

 $10,000.00

 $10,000.00

 $10.00

 $5,000.00

 $15,000.00

 $(5,000.00)

 $20.00

750

 $15,000.00

 $10,000.00

 $10.00

 $7,500.00

 $17,500.00

 $(2,500.00)

 $20.00

1000

 $20,000.00

 $10,000.00

 $10.00

 $10,000.00

 $20,000.00

 $-

 $20.00

1250

 $25,000.00

 $10,000.00

 $10.00

 $12,500.00

 $22,500.00

 $2,500.00

 $20.00

1500

 $30,000.00

 $10,000.00

 $10.00

 $15,000.00

 $25,000.00

 $5,000.00

 $20.00

1750

 $35,000.00

 $10,000.00

 $10.00

 $17,500.00

 $27,500.00

 $7,500.00

 $20.00

2000

 $40,000.00

 $10,000.00

 $10.00

 $20,000.00

 $30,000.00

 $10,000.00

 $20.00

2250

 $45,000.00

 $10,000.00

 $10.00

 $22,500.00

 $32,500.00

 $12,500.00

 $20.00

2500

 $50,000.00

 $10,000.00

 $10.00

 $25,000.00

 $35,000.00

 $15,000.00

               

Scenario 2: Fixed Costs = $15,000, Variable Costs = $7.00

  Quantity Total Fixed Variable Total Total Profit/
  Sold Revenue Costs Costs Per Unit Variable Cost Costs Loss

 $20.00

0

 $-

 $15,000.00

 $7.00

 $-

 $15,000.00

 $(15,000.00)

 $20.00

250

 $5,000.00

 $15,000.00

 $7.00

 $1,750.00

 $16,750.00

 $(11,750.00)

 $20.00

500

 $10,000.00

 $15,000.00

 $7.00

 $3,500.00

 $18,500.00

 $(8,500.00)

 $20.00

750

 $15,000.00

 $15,000.00

 $7.00

 $5,250.00

 $20,250.00

 $(5,250.00)

 $20.00

1000

 $20,000.00

 $15,000.00

 $7.00

 $7,000.00

 $22,000.00

 $(2,000.00)

 $20.00

1154

 $23,080.00

 $15,000.00

 $7.00

 $8,078.00

 $23,078.00

 $2.00

 $20.00

1250

 $25,000.00

 $15,000.00

 $7.00

 $8,750.00

 $23,750.00

 $1,250.00

 $20.00

1500

 $30,000.00

 $15,000.00

 $7.00

 $10,500.00

 $25,500.00

 $4,500.00

 $20.00

1750

 $35,000.00

 $15,000.00

 $7.00

 $12,250.00

 $27,250.00

 $7,750.00

 $20.00

2000

 $40,000.00

 $15,000.00

 $7.00

 $14,000.00

 $29,000.00

 $11,000.00

 $20.00

2250

 $45,000.00

 $15,000.00

 $7.00

 $15,750.00

 $30,750.00

 $14,250.00

 $20.00

2500

 $50,000.00

 $15,000.00

 $7.00

 $17,500.00

 $32,500.00

 $17,500.00

Let’s assume that the new software carries a license fee of $5,000 a month and reduces variable costs per unit from $10.00 to $7.00 Scenario 1 represents the purchasing manager’s current situation without purchasing the computer system and Scenario 2 shows what his firm’s cost structure will look like if he goes ahead and buys the system. There are two important takeaways that we can draw from this example that hold true any time you replace variable costs with fixed costs.

First is that the break-even level of sales rises, in this case from 1,000 units to 1,154. Second is that losses are magnified below the break-even point, while profits increase more rapidly once breakeven has been surpassed; in our example each additional 250 units sold increased profits by $2,500 in Scenario 1 and $3,250 in Scenario 2.

So if our purchasing manager is confident that his company can surpass its breakeven point on a consistent basis, then it probably makes sense to go ahead with the purchase. But if the company’s sales have a history of being choppy and it often operates in the red for months at a time, then buying the new software may be an unwise use of operating leverage.

An easy way to measure your company’s operating leverage is to get out your income statement and balance sheet and calculate your fixed asset turnover ratio by dividing your total sales by your fixed assets. The lower this number is, the more operating leverage you are using.

Of course, using a substantial amount of operating leverage is in itself not necessarily a cause for concern. If you are running an airline or operating a construction-rental equipment business you’re going to need a substantial investment in fixed assets and will thus be utilizing a high degree of operating leverage. That’s just the nature of those businesses.

If, on the other hand, you’re in the clothing retail or software business then you should be employing significantly less operating leverage than those in the aforementioned industries that are more reliant on fixed assets.

So when assessing the appropriate level of operating leverage for your firm it can be very helpful to compare it to publicly traded companies in your industry, most of whom have their financial statements available for free online. And if you’ve got questions about how much leverage you should be using, you’ll definitely want to consult with your accountant or a trusted investment professional.

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101: Capital Structuring
By Gregg Schoenberg Tuesday, March 12, 2013

A few months ago we ran a series of articles on HBS about various methods of raising capital for your business, from friends and family to angel investors, venture capitalists and crowd-funders. But no matter where you wind up raising your capital it will come in one of two forms: debt or equity. The choices you make between these two options will have profound effects on your profitability, tax liabilities, and ability to weather tough times, so let’s take a look a closer look at each one and examine a method for determining a company’s optimal capital structure.

Cost of Debt Capital

The concept of raising capital by issuing debt is fairly simple: you borrow money from someone—be it a bank, a family member, a credit card company, etc.—and agree to pay back the money plus a specified rate of interest. The interest rate represents the return that the lender receives on his investment, so you might think that it also equates to your cost for issuing the debt. But you’d be missing a very important characteristic of debt capital, and one that differentiates it from equity capital: the interest payments you make on your firm’s debt are tax-deductible. Mathematically speaking this means that your cost of debt is equal to the interest rate on the debt multiplied by one minus your tax rate or C=i(1-t). So if you issue debt at 10% and pay taxes at a 20% rate your cost of debt is actually 8%.

Cost of Equity Capital

If you’re raising capital via equity rather than debt, than you aren’t borrowing money from anyone and won’t be making any interest payments. Instead, you are selling an ownership stake in your company along with a corresponding claim on your firm’s future earnings.

While figuring out your cost of debt capital is pretty straightforward, the same cannot always be said for calculating the cost of issuing equity capital. MBAs and other finance professionals use a number of tools such as the capital asset pricing model (CAPM) and Dividend Discount Model (DDM) to help them make educated guesses but those models are fairly complicated and still imperfect so we won’t get into them here.

The important thing to remember is that the cost of equity capital is always higher than the cost of debt capital. There are two reasons for this: first, there is no tax-deduction for equity capital, and second, from the investor’s perspective, equity investments are riskier than debt investments because equity investors do not receive any interest payments in return for their capital and are subordinate to debt investors in the event of a bankruptcy. So equity investors will demand a higher rate of return than debt investors to compensate for this additional risk.

Determining the Optimal Capital Structure

Given that it is cheaper for a company to issue debt as opposed to equity you may be wondering why companies would ever to choose to issue equity. The answer lies in the relationship between the costs of debt and equity and their effect on a firm’s weighted average cost of capital (the total cost of capital based upon the proportions of debt and equity capital raised). A simple table can help exhibit this relationship.

 

ABC Corp’s Cost of Capital

 

Percentage of

Percentage of

Cost of

Cost of

Weighted Avg.

Debt Financing

Equity Financing

Debt Capital

Equity Capital

Cost of

Capital

0%

100%

4%

10%

10.00%

10%

90%

4%

10%

9.40%

20%

80%

4%

10%

8.80%

30%

70%

4%

10%

8.20%

40%

60%

4%

10.5%

7.90%

50%

50%

5%

11.5%

8.25%

60%

40%

6%

13%

8.80%

70%

30%

8%

15%

10.10%

80%

20%

10%

18%

11.60%

90%

10%

15%

22%

15.70%

 

If ABC Corp. doesn’t issue any debt then its cost of capital is equal to the cost of its equity capital, 10%.  But as it begins to issue debt at a cost of 4%, its weighted average cost of capital starts to decline. Up to a certain point. For ABC a mix of 40% debt and 60% equity results in the optimal (lowest) cost of capital of 7.90%. Above 40% debt, the cost of equity and debt capital starts to rise, leading to a higher overall cost of capital. The reasons behind this are pretty simple: if a company takes on too much debt then it increases the likelihood that it won’t be able to repay that debt, and it becomes a riskier investment for both debt and equity investors.

Hopefully this gives you a nice 101 on Capital Structuring; the differences between equity and debt capital and their impact on the total cost of capital. When it comes time to raise money for your firm, you may want to go into grater detail by reading more in a corporate finance textbook and consulting an investment-banking expert who can help determine your optimal capital structure.

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Launching New Ideas for Your Small Business
By Jamillah Warner Monday, March 11, 2013

Your goal is to launch a new project. The best ideas, however, never get off the ground without a lot of time to plan them. Short of approving overtime for everyone on your team, there are a few alternative steps you can take. With these three actions, you can push your project to the next level.

(A) Plan First 

When your time is limited, you have less room for trial and error. Brainstorming  for weeks in the wrong direction can deflate your team. Before you share your ideas for a new project with your team, be sure you have a solid and specific plan ready to discuss with them.

Just as research should precede writing, planning should precede action. However, this step is often overlooked because it feels slow or tedious. Movement — even if it’s only busy work — makes you feel like you’re getting something done. Slowing down, however, can make the difference between a plan that works and one that falters. Planning is one of the wise steps for which you must slow down.

Start by yourself (or perhaps include one team member). Start digging into the research and testing the waters. If you decide, for example, to launch a new marketing strategy, you will want to know:

1.Who has done this before in my industry? Can I talk to them and get a first-hand perspective?

2.Who has done something like this before in any industry?

3.What type of money will I need in order to start?

4.Who are the key team members and how much time would it take out of their regular work day?

5.Can I redirect some of their work to a different team member in order to make room for this marketing project?

6.What will be involved in maintaining it after it’s launched?

Once you complete the initial planning and findthe answers to your core questions, then you’re ready for the next step.

(B) Take One

At first, you don’t need to dedicate entire weeks to a new project. One solid, focused hour a day can keep your plan moving forward. I have written and launched entire programs for a non-profit using this same process. The key to maximizing those 60 minutes is figuring out whether the first or the last hour of the day works best for you. Once you know, protect that time.

If you just cannot get the work accomplished during your regular work hours, do whatever is necessary to find the time: slip into your office one hour early, do your planning from home or drop by a coffee shop for a long lunch--find a plan and stick with it. Consistent behavior makes a huge difference.

(C) Clear Direction 

When it’s time to bring in additional team members, offer them clear directions. Years of managing volunteers and an under-paid team of community servants has led to a few basic revelations:

People will respond to your passion. 

If you’re excited about the project, your excitement will transfer to your team.

People will lose focus if you’re indecisive. 

Understand what you want from them before you start the conversation.

People respond to time-sensitive, measurable directions. 

Instead of saying, “I wonder if the local art gallery will partner with us for this marketing project?”, be more direct. Tell a team member: “Contact the art gallery director and assistant director. Let them know about the project, that we’re looking for a partner organization, and ask them what it will take to work with them. Let me know by 5 PM today. Thanks.”

Be kind, but be clear.

People appreciate kindess and clarity.

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