CAPITAL STRUCTURE AND LEVERAGE

“When we leverage, we aggregate and organize existing resources to achieve success.”

― Richie Norton.
After studying this chapter, students should be able:
 To discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and
the effect of changing costs on it.
 To understand operating, financial, and total leverage and the relationships among them.
 To compute the degree of financial leverage and how does it affect EPS and ROE.
 To describe the types of capital, external assessment of capital structure, and capital structure
theory.
 To explain the optimal capital structure using a graphical view of the firm’s cost-of-capital
functions and a zero-growth valuation model.
 To explain how financial leverage affects earnings per share (EPS) and return on equity
(ROE).
 To explain why determining the optimal capital structure is important.

The assets of a company can be financed either by increasing the owners' claims or the creditors’
claims. The owners' claims increase when the firm raises funds by issuing ordinary shares or by
retaining the earnings; the creditors' claims increase by borrowing. The various means of
financing represent the financial structure of an enterprise. The left-hand side of the balance
sheet represents the financial structure of a company.

Traditionally, short-term borrowings are excluded from the list of methods of financing the
firm’s capital expenditure, and therefore, the long-term claims are said to from the capital
structure of the enterprise. The term capital structure is used to represent the proportionate
relationship between debt and equity. Equity includes paid up share capital, share premium and
reserves and surplus.

The financing or capital structure decisions is a significant managerial decision. It influences the
shareholder's return and risk. Consequently, the market value of the share may be affected by the
capital structure initially at the time of its promotion. Subsequently, whenever funds have to be
raised to finance investments, a capital structure decision is involved. A demand for raising funds
generates a new capital structure since a decision has to be made as to the quantity and forms of
financing. This decision will involve an analysis of the existing capital structure and the factors,
which will govern the decision at present. The dividend decision, is, in a way, a financing
decision. The company's policy to retain or distribute earnings affects the owners' claims.
Shareholders' equity position is strengthened by retention of earnings. Thus, the dividend
decision has a financing decision of the company may affect its debt-equity mix. The debt-equity
mix has implications for the shareholders' earnings and risk, which in turn, will affect the cost of
capital and the market value of the firm.

The management of a company should seek answers to the following questions while making the
financing decision:
 How should the investment project be financed?
 Does the way in which the investment projects are financed matters?
 How does financing affect the shareholders' risk, return and value?
 Does there exist an optimum financing mix in terms of the maximum value of the firm’s
shareholders?
 Can be optimum financing mix be determined in practice for a company?
 What fact ores in practice should a company consider in designing its financing policy?

In finance, leverage is defined as the ability of a firm to use fixed cost assets or fund to magnify
the returns to the shareholders. In general term, it is a technique which can multiply gains and
losses. According to G.A. Chisty and F.F. Roden, “Leverage means the tendency to change profit
at faster rate than sale”.

There are three types of Decisions, Such as Investment Decisions, Financing Decisions and
Dividend Decisions.

Leverage is an investment techniques in which a small amount of own money is used to make an
investment of larger value. Leverage gives a financial manager a significant financial power.

Leverage is defended as the employment of assets or sources of funds for which the firm has to
pay a fixed cost or fixed return and investing the available fund in order to get the larger value
against investment.

Leverage is to invest the amount of debt resources for getting large return. The amount of debt
used to finance firms assets falls under the leverage discussion. A firm with significantly more
debt than equity is considered to be highly leveraged.

If the debt financing is higher, then Leverage will be higher.

If the debt financing is lower, then Leverage will be lower.

Degree of Leverage: “A measure at a given level of sales of how a percentage changes in sales
volume will affect profits. The degree of operating Leverage is computed by dividing
contribution margin by net operating income.”

For Example:
a) If you borrow 90% of the cost of a house, you are using the leverage to buy a much more
expensive property than you could have afforded by paying cash.
b) If you sell the property for more than you borrowed, the profit is entirely yours. The reverse is
also true. If you sell at a loss, the amount you borrowed is still due and the entire loss is yours.

Leverage may be favorable and unfavorable.

Situation of Leverage: There are two (2) situations of leverage:

Favorable Leverage: If the earnings less the variable costs exceed the fixed costs or earnings
before interest and taxes (EBIT) exceeds the fixed return requirement, the leverage is called
favorable.
Unfavorable Leverage: If the earnings less the variable costs not exceed the fixed costs or
earnings before interest and taxes (EBIT) not exceeds the fixed return requirement, the leverage
is called unfavorable.

Favorable Unfavorable
(Earning –VC)> FC (OL) (Earning –VC)< FC

Earning or EBIT > Fixed interest Change (FL) Earning or EBIT< Fixed Interest charges.

Types of Leverage: There are basically three types of Leverage:

1. Operating Leverage OL (Equity)

2. Financial Leverage FL (Debt/Loan)
3. Combined Leverage CL ( Operating and financial)

Operating Leverage: Leverage associated with the assets acquisitive investment activities is
referred to as operating leverage. It may be also define as the ability to use the fixed operating
cost to magnify the effect of change in sales on its operating profits (EBIT).
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.

Degree (Change) of Leverage: DOL, DFL, DCL

Degree of operating Leverage: (DOL): By using fixed operating cost, a small change in sales
revenue that magnified into a larger change in operating income/EBIT.
Operating leverage involves using a large proportion of fixed costs to variable costs in the
operations of the firm. The higher the degree of operating leverage the more volatile the EBIT
figure will be relative to a given change in sales, all other things remaining the same. It may be
determined by the relationship between sales revenue & EBIT.

Percentage change in EBIT

DOL= ------------------------------------(Small changes in Sales , Large change in EPS)
Percentage change in Sales

IF DOL=2, then a 1% increase in sales will result in a 2 % increase in operating income.

Financial Leverage FL: Financial leverage is the 2nd types of leverage which is related to the
financing decision of a firm. It results from the presence of fixed firm charges.
Degree of Financial Leverage: (DFL): Using debt financing, a small change in EBIT that
magnified in to larger change in earning per share.
Percentage change in EPS
DFL = --------------------------------- (Small changes in Sales, Large change in EPS)
Percentage in EBIT
If DFL = 3, then a 1% increase in operations income will result in a 3% increase in earning per
share.

Combined Leverage: CL: A leverage ratio that summarizes the combined effect the degree of
operating leverage (DOL), and the degree of financial leverage has on earnings per share(EPS),
given a particular change in sales. This ratio can be used to help determine the most optimal level
of financial and operating leverage to use in any firm.

Degree of Combined Leverage: (DCL): It is the combined effect of DOL and DFL. By using
operating leverage and financial leverage, a small changes in sales that magnified into larger
changes in Earning Per Share (EPS).
% Changes in EPS
DCL=--------------------------------- = DOL X DFL
% Changes in Sales

DOL DFL
Sales EBIT EPS Shareholders

Difference between Operating Leverage and Financial Leverage:

Difference between Operating Leverage and Financial Leverage.

The differences between Operating Leverage and Financial Leverage are as follows:

Features of Difference Operating Leverage Financial Leverage

1.Definition/Arises Operating Leverage arises Financial Leverage arises from

from the cost structure the capital Structure.
2.Determination It is determined by the It is determined by the
relationship between Sales relationship between EBIT and
and EBIT EPS.
3.Risk Degree of Operating leverage Degree of financial leverage
creates Business Risk. creates financial Risk.

4. Formula Used DOL=Sales-VC/EBIT DFL=EBIT/EBIT-I

5. Affects It affects the sales and EBIT IT affects the EBIT and EPS.

6. Use/Fulcrum In operating leverage the In financial leverage the

fulcrum is the fixed cost. fulcrum is the fixed interest
charges that must be paid to
service the long term debt.

Risk involves in Leverage:

Two concepts that enhance our understanding of risk.

1. Operating Leverage-----affects a firm’s business risk.

2. Financial Leverage------affects a firm’s financial risk

Business Risk: The variability or uncertainty of a firm’s operating income (EBIT).

Business Risk:

1. Sales volume variability

2. Competition
3. Growth
4. Product Diversification
5. Operating Leverage
6. Growth Prospects
7. Size.

Financial Risk: The variability or uncertainty of a firm’s earnings per share (EPS) and the
increased probability of insolvency that arises when a firm uses financial leverage.
Earning Per Share (EPS): What Does Earnings per Share (EPS) mean?

 EPS is net income minus dividend on preferred stock divided by the number of shares
outstanding.
 The portion of a company’s profit allocated to each outstanding share of common stock. EPS
serves as an indicator of a company’s profitability.

Calculations As: Net Income - Dividend on preferred stock

No of shares outstanding

For Example: Assume that a company has a net income of Tk 25 Millions. If the company pays
out 1 million in preferred dividends and no of shares outstanding is Tk 10 millions.
EPS= 25-1 = 24/10 = 2.4
10

Example of Levered Firm/Company:

Sales (1,00,000 units) Tk 14,00,000

variable Costs 8,00,000
Fixed Costs 2,50,000
Interest Paid 1,25,000
Tax Rate @ 34 %
Common Shares Outstanding Tk 1,00,000

Degree of Operating Leverage from Sales Level:

DOL= Sales-VC/EBIT = (1,400,000 - 800,000)/350,000
 = 600,000/350,000
= 1.714%

So, 1% increases of Sales means EBIT will increase by 1.714%.

Meaning of Financial Leverage

As stated earlier, a company can finance its investments by debt and equity. The company may
also use preference capital. The rate of interest on debt is fixed irrespective of the company's rate
of return on assets. The company has a legal binding to pay interest on debt. The rate of
preference dividend is also fixed; but preference dividends are paid when the company earns
profits. The ordinary shareholders are entitled to the residual income. That is, earnings after
interest and taxes (less preference dividends) belong to them. The rate of the equity dividend is
not fixed and depends on the dividend policy of a company.

The use of the fixed-charges sources of funds, such as debt and preference capital along with the
owners' equity in the capital structure, is described as financial leverage or gearing or trading on
equity. The use of the term trading on equity is derived from the fact that it is the owner's equity
that it is used as a basis to raise debt ; that is, the equity that is traded upon. The supplier of the
debt has limited participation in the company's profit and, therefore, he will insist on protection
in earnings and protection in values represented by ownership equity.

The financial leverage employed by a company is intended to earn more return on the fixed-
charge funds than their costs. The surplus or deficit will increase or decrease the return on the
owners' equity. The rate of return on the owners' equity is leverage above or below the rate of
return on total assets. For example, if a company borrows 100 million taka at 16% interest and
invests it to earn 18% return, the balance of 2% after payment of interest will belong to the
shareholders, and it constitutes the profit from financial leverage. On the other hand, if the
company could earn only a return of 14% on 100 million taka, the loss to the shareholders would
be 2 million taka per year. Thus, financial leverage at once provides the potentials of increasing
the shareholders' earnings as well as creating the risks of loss to them. It is a double-edged
sword.

The higher the fixed cost, higher the variability in earnings before interest and tax for a given
change in sales. Other things remaining the same, companies with higher operating leverage are
more risky.

Operating leverage intensifies the effect of cyclically on a company’s earnings. As a

consequence, companies with higher degree of operating leverage have high betas.

Financial Leverage

Financial leverage refers to debt in a firm’s capital structure. Firms with debt in the capital
structure are called leveraged firms.

The interest payments on debt are fixed irrespective of the firm’s earnings. Hence, interest
changes are fixed costs of debt financing. The fixed costs of operations result in operating
leverage and caused earnings before interest and tax to vary with changes in sales.

Similarly, the fixed financial costs result in financial leverage and cause profit after tax to vary
with changes in earnings before interest and tax. Hence, the degree of financial leverage is
defined as the change in a company’s profit after tax due to change in its earnings before interest
and tax. Since financial leverage increases the firm’s financial risk, it will increase the equity
beta of then firm.
Assess the impact of the following events on a firm’s operating leverage:
a. An increase in output price due to increased demand.
b. A decrease in fixed cost.
c. Negotiation of a new contract with suppliers leading to higher commitments to purchase raw
materials.
d. Lowered variable labor costs per unit of output.
e. Installation of new machine tools that lower variable production costs per unit of output.
In general, factors that increase the level of fixed costs within a firm also increase its operating
leverage. Therefore, event (b) reduces operating leverage while event (c) increases operating
leverage. The opposite effect prevails for variable costs. Events (a) and (d) increase the
contribution margin, and therefore reduce operating leverage. Event (e) affects both fixed and
variable costs; the dominant effect is uncertain.
Consider two firms, one American and the other Japanese, using identical production processes;
that is, they use the same equipment and hire the same number of workers. However, the
Japanese firm follows a no-layoff policy, whereas the American firm is willing to alter its work
force in line with changing market conditions. Which company will have the larger amount of
operating leverage? Why? How will the difference in amounts of operating leverage affect their
marketing and production decisions and strategies?
The Japanese firm will have greater operating leverage. For their firm, labor is considered a
fixed cost. Increased fixed costs increase operating leverage. The American firm has the option
to adjust the level of labor according to changes in market conditions. This option comes at a
cost. With a lower marginal cost of production, the Japanese firm will continue to produce when
the Americans lose money in production. Since their marginal cost is lower, they will sell at a
lower price and seek to aggressively capture market share; they will continue to produce as long
as marginal revenue exceeds marginal costs, regardless of their overall profitability. The
Japanese firm will emphasize sales growth since for them, with a low marginal cost of
production, revenue and profit are virtually identical.

Example, If Fantasia inc. follows its normal policy of hiring long-term employees, each extra
taka of sales results in a change of Tk.1.00 – Tk.8125 = Tk.1875 in pretax profits. If it uses
temporary labor, an extra taka of sales leads to a change of only Tk.1.00 – Tk.84 = Tk.16 in
profits. As a result, a store with high fixed costs is said to have high operating leverage. High
operating leverage magnifies the effect on profits of a fluctuation in sales.
You can measure a business’s operating leverage by asking how much profits change for each 1
percent change in sales. The degree of operating leverage, often abbreviated as DOL, is this
measure.

DOL = Percentage change in Profits

Percentage change in sales

DOL = ∆ EBIT
EBIT1
∆ SALES
SALES1

For example, Table below shows that as the store moves from normal conditions to boom, sales
increase from Tk.16 million to Tk.19 million, a rise of 18.75 percent. For the policy with high
fixed costs, profits increase from Tk.550,000 to Tk.1,112,000, a rise of 102.2 percent. Therefore,

102.2
DOL= =5.45
18.75

OPERATING LEVERAGE Degree to which costs are fixed.

DEGREE OF OPERATING LEVERAGE (DOL) Percentage change in profits given a 1 percent
change in sales.

TABLE: Astore with high operating leverage performs relatively badly in a slump but
flourishes in a boom (figures in thousands of takas)
High Fixed Costs High Variable Costs

Slump Normal Boom Slump Normal Boom

Sales 13,000 16,000 19,000 13,000 16,000 19,000
– VC 10,563 13,000 15,438 10,920 13,440 15,960
– FC 2,000 2,000 2,000 1,560 1,560 1,560
– Dep. 450 450 450 450 450 450

EBIT – 13 550 1,112 79 550 1,030

Now look at the operating leverage of the store if it uses the policy with low fixed costs but high
variable costs. As the store moves from normal times to boom, profits increase from Tk.550,000
to Tk.1,030,000, a rise of 87.3 percent. Therefore,
87.3
DOL= =4.65
18.75

Because some costs remain fixed, a change in sales continues to have a magnified effect on
profits but the degree of operating leverage is lower.
In fact, one can show that degree of operating leverage depends on fixed charges (including
depreciation) in the following manner:
 ¿ costs
DOL=1+
profits

This relationship makes it clear that operating leverage increases with fixed costs.

LEVERAGE AND CAPITAL STRUCTURE

How should a firm go about choosing its debt-equity ratio? Here, as always, you assume that the
guiding principle is to choose the course of action that maximizes the value of a share of stock.
However, when it comes to capital structure decisions, this is essentially the same thing as
maximizing the value of the whole firm, and, for convenience, you will tend to frame our
discussion in terms of firm value.

The WACC (Weighted Average Cost of Capital) tells you that the firm’s overall cost of capital is
a weighted average of the costs of the various components of the firm’s capital structure. When
you described the WACC, you took the firm’s capital structure as given. Thus, one important
issue that you will want to explore is what happens to the cost of capital when you vary the
amount of debt financing, or the debt-equity ratio.

A primary reason for studying the WACC is that the value of the firm is maximized when the
WACC is minimized. The WACC is the discount rate appropriate for the firm’s overall cash
flows. Since values and discount rates move in opposite directions, minimizing the WACC will
maximize the value of the firm’s cash flows.

Thus, you will want to choose the firm’s capital structure so that the WACC is minimized. For
this reason, you will say that one capital structure is better than another if it results in a lower
weighted average cost of capital. Further, you can say that a particular debt equity ratio
represents the optimal capital structure if it results in the lowest possible WACC. This optimal
capital structure is sometimes called the firm’s target capital structure as well.

The Effect of Financial Leverage

In this section, you examine the impact of financial leverage on the payoffs to stockholders. As
you may recall, financial leverage refers to the extent to which a firm relies on debt. The more
debt financing a firm uses in its capital structure, the more financial leverage it employs.
As you describe, financial leverage can dramatically alter the payoffs to shareholders in the firm.
Remarkably, however, financial leverage may not affect the overall cost of capital. If this is true,
then a firm’s capital structure is irrelevant because changes in capital structure won’t affect the
value of the firm.

EXAMPLE:

Leverage is generally defined as the ratio of the percentage change in profits to the percentage
change in sales. In other words, leverage is the multiplying effect that fixed costs have on profits
when there is any change in sales. As sales increases or decreases, it is only the variable costs
that change correspondingly, fixed costs remain constant. Profits therefore increase or decrease
at a faster rate than the rate of change in sales. This can be better understood with an example.

A hypothetical income statement for a firm is as follows:

Sales 2000
Less: Variable costs 800
------
Contribution 1200
Less: Fixed costs 500
------
Profits 700
------

If the sales of this firm is increased by 20%, the income statement will stand revised as follows:

Sales 2500 (increase of 25%)

Less: Variable costs 1000 (increase of 25%)
------
Contribution 1500 (increase of 25%)
Less: Fixed costs 500 (No change)
--------
Profits 1000
---------

With an increase in sales of 25% from Tk. 2,000 to Tk. 2,500, profits have increased from Rs.
700 to Tk. 1000, an increase of 43%. This is the effect of leverage. If the firm had no fixed costs
at all but all its costs were variable, there would have been no leverage and the percentage
change in sales would have been the same as the percentage change in profits. It is fixed costs
that introduce leverage into the firm and higher the fixed cost, higher is the leverage.

Impact of Financial Leverage on Investor’s Rate of Return

Let us understand how financial leverage affects investor’s return on equity by the following
illustration. A company needs a capital of Tk. 10,000 to operate. This fund may be brought by
the shareholders of the company. Alternatively, a part of this amount may be brought in through
debt financing. If the company has money only from the shareholders than the company is not
financially leveraged and would have the following balance sheet.

High fixed costs and low variable costs provide the greater percentage change in profits both
upward and downward. If a high percentage of a company’s cost are fixed, and do not decline
when demand decreases, this increases the company’s business risk. This factor is called
operating leverage. If a high percentage of a company’s total costs are fixed, the company is said
to have a high degree of operating leverage. The degree of operating leverage (DOL) is defined
as the percentage change in operating income (or EBIT) that results from a given percentage
change in sales. In effect, the DOL is an index number which measures the effect of a change in
sales on operating income, or EBIT. When fixed costs are very large and variable costs consume
only a small percentage of each rupee of revenue, even a slight change in revenue will have a
large effect on reported profits .Operating leverage, then, refers to the magnified effect on
operating earnings (EBIT) of any given change in sales. One of the most dramatic examples of
operating leverage is in the airline industry, where a large portion of total costs are fixed.

Thus, in general terms, operating leverage is defined as the percentage change in the earnings
before interest and taxes relative to a given percentage change in sales.

The degree of operating leverage is also defined as the change in a company’s earnings before
interest and tax due to change in sales. Since variable costs change in direct proportion of sales
and fixed costs remain constant, the variability in EBIT when sales change is caused by fixed
costs. Operating leverage refers to the use of fixed costs in the operation of a firm. A firm will
not have operating leverage if its ratio of fixed costs to total cost is nil. For such a firm, a given
change in sales would produce same percentage change in the operating profit or earnings before
interest and taxes.

Fixed operating costs include administrative costs, depreciation, selling and advertisement
expenses etc. With positive ( i.e. greater than zero) fixed operating costs , a change of 1 % in
sales produces a more than 1% change in Earnings Before Interest and Taxes (EBIT). A measure
of this effect is referred to as the Degree of Operating Leverage ( DOL). Thus DOL measures the
responsiveness of operating income (EBIT) to change in the level of output and indicates its
impact on profits when the levels of sales vary. Specially, DOL is defined as the percentage
change in operating income (EBIT) divided by the percentage change in the level of output.

Overview of Capital Structure

Solomon defines “Financial Management is concerned with the efficient use of an important
economic resource, namely capital funds”; this definition clearly reveals that the prime objective
of Financial Management is Procurement of funds and Effective use of these funds to achieve
business objectives.
   
A scientific analysis of these instruments and its mobilization has a considerable significance in
the real life situation. An unplanned capital structure may yield good result in the short run but it
is dangerous in the long run. Hence the study of capital structure is become more relevance.
      
Capital structure planning keyed to the objective of profit maximization ensures the minimum
cost of capital and the maximum rate of return to equity holders. The proper mix of debt and
equity play major part in capital structure, capital structure analysis helps to identify how much
that organization raise their fund in the form of equity and debt. A financial manager determines
the proper capital structure for the firm.

Meaning of Capital structure

   
Capital Structure refers to the mix of sources from where the long term funds required in a
business may be raised, i.e. what should be the proportions of the equity share capital, preference
share capital, internal sources, debentures, and other sources of funds in the total amount of
capital which an undertaking may raise for establishing its business.    

Features of Appropriate Capital Structure:

1. Profitability: The most profitable capital structure is one which tends to minimize the cost of
financing and maximize earnings per share.
2. Flexibility: The capital structure should such that company can raise funds whenever needed.
3. Conservation: The debt content in the capital structure should not exceed the limit which a
company can bear.
4. Solvency: The capital structure should be such that the firm does not run the risk of becoming
insolvent.
5. Control: The capital structure should be so devised that it involves minimum risk of loss of
control.   

Factors Determining Capital Structure

   
The capital structure decisions have to be planned in the initial stages of a company. It is a
management decision aims at supplying the required amount of capital. The role of finance
manager in deciding the amount of capital structure is significant he has to study and analyze the
benefits and defects of issuing each type of securities.

Factors influencing capital structure:

1. Financial leverage
              
The use of fixed bearing securities, such as debt and preference capital along with owner’s equity
in the capital structure is described as ‘Financial leverage’. This decision is most important from
the point of view of financing decision. By having debt and equity in the capital mix, accompany
will have an opportunity of deployment certain amount of debt with an intention enjoy the
benefit of reduction in the percentage tax. The benefit so enjoyed will be passed on to the equity
shareholders in the form of high percentage of dividend.

2. Risk

Ordinarily, debt securities increase the risk, while equity securities reduce the risk. Risk can be
measured to some extent by the use of ratio, measuring gearing and time –interest earned. The
risk attached to the use of leverage is called ‘Financial risk’. Financial risk is added with the use
of debt because of increased variability in the shareholders earnings. A firm can avoid the risk by
doesn’t employ debt capital in the capital mix.

3. Growth and Stability

In the initial stages, a firm can meet its financial requirement through long-term sources,
particularly by raising equity shares when a company starts getting good response and cash
inflow capacity is increased through sales, company can raise debt or preference capital for
growth and expansion programmes of the company. The company which is having high sales
revenue will opt for more amount of debt for their financial requirement. In contrast to this when
company which having less sales revenue must reduce its burden towards debt.

4. Retaining control
       
The attitude of the management towards retaining the control over the company will have direct
impact on the capital structure. If the existing shareholder wants to continue the same holding on
the company, they may not encourage the issue of additional equity shares. The issues of
debenture and preference share will also influenced by the reputation that is enjoyed by the
company. If the credit worthiness of a firm is good; it can raise the funds according to the desire
of the existing shareholders.

5. Cost of capital
       
The cost of capital refers to the expectation of suppliers to funds. The objective of knowing the
cost of capital is to increase the return on investment, so that, a firm should earn sufficient profits
to repay the interest and installment of principal to the lenders. The market value of equity share
does not fall because of minimum rate of return. The cost of debenture is assessed by taking the
assured percentage of interest. The fund borrowed from bank or financial institutions will have
the cost of interest. The source of preference share capital will have cost of percentage of
dividend. Debt is the cheaper source of fund when compared to other sources. Careful decision
has to be made in selecting the size of debt, because, beyond a particular ratio debt increase the
risk of the firm. Hence cost of capital influences the capital structure.

6. Cash flows
       
Cash flow ability of a company will have direct impact on the capital structure. Cash flow
generation capacity of a firm increases the flexibility of the capital structure. Cash flow permits
the company to meet its short term obligations. A firm will have the obligation to pay dividend to
equity share holders, interest to bankers and debenture holders. Sound cash flow facilitates the
company to raise funds through debt. Insufficient availability of cash or cash inflow takes the
company to a disastrous situation.

CAPITAL STRUCTURE THEORIES

Capital Structure Theories:

   
The objective of a firm should be directed towards the maximization of the value of the firm, the
capital structure, or the leverage decision should be examined from the point of view of its
impact on the value of firm, there are broadly three approaches or theories to study the capital
structure they are as below:

1) Net Income Approach.

2) Net Operating Income Approach.
3) Modigliani and Miller Approach.
These approaches analyses the relationship between the leverage, cost of capital, and the value of
firm in different ways, however the following assumptions are made to understand these
relationship.

 There are only two sources of Finance i.e. Debt and Equity.
 The degree of leverage can be changed by selling debt to repurchase shares or selling
shares to retire debentures.
 There are no retained earnings; it implies that entire profit is distributed to shareholders.
 The Operating profit of the firm is given and it is expected to grow.
 The business risk is assumed to be constant and is not affected by the financing mix
decisions.
 There are no corporate or personal taxes.
 The investors have same subjective probability distribution of expected earnings.

Net Income Approach:

This Approach has been suggested by Durand. According to this approach a firm can increase its
value or lower the overall cost of capital by increasing the proportion of debt in the capital
structure. In other words if the degree of financial leverage increases the weighted average cost
of capital will decline with every increase in the debt content in total funds employed, while the
value of the firm will increase. Reverse will happen in converse situation. Under this approach
the value of a firm will be maximum at a point where weighted average cost of capital is
minimum.

 The use of debt does not change the risk perception of investors.
 Debt capitalization rate is less than the equity capitalization rate.
 Corporate income taxes do not exist.

Net Operating Income Approach:

According to net operating approach, the overall capitalization rate and the cost of debt remain
constant for all degrees of leverage. The cost of debt, equity and overall capitalization in
response to change in market value of debt and equity. The critical premise of this approach is
that the market capitalizes the firm as a whole at a discount rate which is independent of the
firm’s debt-equity ratio is a consequence, the division between debt and equity is irrelevant. An
increase in the use of debt funds which are apparently cheaper is offset by an increase in the
equity capitalization rate. This approach follows certain assumptions

 The market capitalizes the value of the firm as a whole (split between debt and equity is not
important)
 The market uses an overall capitalization rate depending on business risk
 Use of less costly debt funds increases the risk of shareholders
 Debt capitalization rate is a constant
 Corporate income taxes do not exist.
Modigliani and Miller Position

The Modigliani miller results indicate that the firm cannot change the value of a firm by
repacking the firm’s securities. This approach argues that the firm’s overall cost of capital cannot
be reduced as debt is substituted for equity, even though debt appears to be cheaper than equity.
The reason for this is that as firm adds debt. As this risk rises, the cost of equity capital rises as a
result. MM prove that the two effects exactly offset each other, so that the value of the firm and
the firm’s overall cost of capital are invariant to leverage. The following are the assumptions
followed by MM approach.

 The market capitalizes the value of the firm as a whole, which makes the split between debt
and equity unimportant
 The market uses an overall capitalization rate to capitalize the NOI. This overall
capitalization depends on the business risks.
 The use of less costly debt funds increases the risk of shareholder which causes the increase
of   overall capitalization rate.
 The debt capitalization rate is constant.
 The corporate Income-tax does not exist.

State whether each of the following statements is True (T) or False (F)

1. The financing decision affects the total operating profits of the firm.
2. The equity Shareholders get the residual profit of the firm.
3. There is no difference of opinion on the relationship between capital structure and value of the
firm.
4. The traditional approach says that a firm may attain an optimal capital structure.
5. At optimal capital structure, the ke of the firm is highest.
6. The extent to which fixed costs are used in a firm’s operations is called it’s a financial
leverage.
7. Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less
financial leverage. Therefore, the variability of both firms' expected EBITs could actually be
identical.
8. Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT.
9. Two firms could have identical financial and operating leverage, yet have different degrees of
risk as measured by the variability of EPS.

MULTIPLE CHOICE QUESTIONS:

1. The term “capital structure” refers to:
A) Long-term debt, preferred stock, and common stock equity.
B) Current assets
C) Total assets minus liabilities
D) Stockholder’s equity.

2. A firm should select the capital structure that

A) Produces the highest cost of capital
B) Produces the lowest cost of capital
C) Maximizes the value of the firm
D) All of the above

3. An unlevered firm is a company that has

A) No debt B) No equity C) half debt & half equity D) none

4. The effect of financial leverage on the performance of the firm depends on:
A) The firm’s level of EBIT
B) The rate of return on equity
C) The current market value of the debt
D) None of the above

5. A firm has a debt-to-equity ratio of .50. Its cost of debt is 12%. Its overall cost of capital is
14%. What is its cost of equity if there are no taxes or other imperfections?
A) 13% 16% C) 15% D) none

6. If a firm is unlevered and has a cost of equity capital 9% what would the cost of equity be if
the firms became levered at 1.75? The expected cost of debt would be 7%.
A) 12.5% B) 14.5% C) 16% D) 15.75%

7. A firm has zero debt in its capital structure. Its overall cost of capital is 8%. The firm is
considering a new capital structure with 50% debt. The interest rate on the debt would be 5%.
Assuming that the corporate tax rate is 40%, its cost of equity capital with the new capital
structure would be:
A) 9.2% B) 9.8% C) 11% D) 8.9%

8. A firm has a debt-to-equity ratio of 1.0. If it had no debt, its cost of equity would be 14%. Its
cost of debt is 10%. What is its cost of equity if the corporate tax rate is 50%?
A) 12% B) 14% C) 16% D) 18%

9. The existence of __________ on the balance sheet generates tax advantages that directly
influence the capital structure of the firm.
A) Long term debt B) equity C) inventory D) none
SHORT QUESTIONS:

1. What do you mean by capital structure and optimum capital structure?

2. Discuss the feature of a sound capital structure.
3. What do you mean by financial leverage?
4. What do you mean by operational leverage?
5. What is the relationship between financial leverage and EPS of a company?
6. Should you include floatation cost when calculating your cost of capital? Explain.

BROAD QUESTIONS:

1. What is leverage? Explain three types of leverages in details.

2. What factors influence the capital structure? Discuss please.
3. What are the important features of appropriate capital structure?
4. What are the three major theories to study the capital structure? Explain.
5. From the following selected operating data, determine the degree of operating leverage. Which
company has the greater amount of business risk and why? Give you answer.

Details Company X in Tk Company Y in Tk

Sales 25,00,000 30,00,000
Fixed Costs 7,50,000 15,00,000

Variable expenses as a percentage of sales are 50% of Firm X and 25% for Firm Y

6. ABC Company Ltd has an average selling price of Tk.10 per unit. Its variable costs are Tk.7
and fixed costs are amount to Tk. 170,000. It finances all its assets by equity funds. It pays 50%
tax on its income. PQR Company Ltd is identical except respect of pattern of financing. The late
finances its assets 50% by equity and 50% debt. The interest on which amount to Tk.20,000 for
PQR Co.
Determine the degree of operating Leverage, Financial Leverage and Combined Leverage at Tk
7, 00,000 sales for both of the firms and interpret the result.

1. Crown Industries, a well established firm in plastics, is considering the purchase one of
the two manufacturing companies. The financial manager of the company has developed
the following information about the two companies. Both companies have total assets of
Tk 1,5 00,000.
 Operating Income Statement

Particulars Company A Company B

Sales Revenue 30,00,000 30,00,000
Less: Cost of Goods sold 22,50,000 22,50,000
Less: Selling Expenses 2,40,000 2,40,000
Less: Administrative Exp. 90,000 1,50,000
Less: Depreciation 1,20,000 90,000
EBIT 3,00,000 2,70,000
Variable Cost:
Cost of Goods Sold 9,00,000 18,00,000
Selling Expenditures 1,50,000 1,50,000
Total Variable Cost 10,50,000 19,50,000

a). Calculate the degree of operating leverage.

b) . If Crown industries wishes to buy a company which has a lower degree of business risk,
which company would you be purchases by it?

8. The operating and cost data of XYZ Company Ltd are:

Sl Particular Amount in Tk.

1 Sales 20,00,000
2 Variable Cost 14,00,000
3 Fixed Cost 4,00,000 (including 15% interest
on 10,00,000)

a) Calculate its Operating, Financial and Combined Leverage

b) Determine the additional sales to double its EBIT.

9. A firm has sales of Tk 20, 00,000 …, variable cost of Tk 14,00,000 , fixed cost of Tk 4,00,000
and a debt of Tk 10,00,000 @ 10%.

a) Calculate its operating, fixed changes and combined leverage

b) It the firm decides to double it EBIT, how much of a rise in sales would be needed on a
percentage basis?

10. From the following financial data of Companies X and Y, Prepare their income statements.

Particulars Company P Company Q

Variable cost as % of Sales 50 60
Interest paid 20,000 6,000
Degree of operating leverage 3-1 (Highest) 5-1 (Highest)
Degree of Financial Leverage 2-1 3-1
Income Tax Rate @ 55% @ 55%
Reference Books:
1. R.A Brealey, S.C Myers & A. J. Marcus, Fundamentals of Corporate Finance New york. MC
Graw Hill. Inc 1995.
2. Gitman, L.J. & Moses, E.A. Financial Management: Cases, Minnesota: West Publishing Co.
1987.
3. Srivastava Rajiv & Misra Anil. Financial Management: Oxford University press.
4. Johnson, R.W. “Financial Management” Boston: Allyn & Bacon, 1977.
5. Kuchhal, S.C Financial Management: An Analytical and Conceptual Approach, Alahabad:
Chaitanya Publishing House, 1980.
6. Khan. M.Y. & Jain P.K., “Financial Management” 3 rd Edition. 1999 New Delhi; Tata
McGraw Hill Publishing Co., 1981.
7. Pandeym I.M, “Financial Management” New Delhi; Educational Books, 1999.
8. Van Horne J.C “Financial Management” and Policy, Englewood Cliffs, N.J: Prentice Hall
International, 1987.
9. Weston, J.F & Brigham, E.E, Managerial Finance, New Delhi; Prentice Hall, Rivehart &
Winston, 1996.
10. Robert Hitchinson. Corporate Finance, Principles of Investment, Financing and Valuation:
Stanley Thornes (Publishers) Ltd. Cheltenham Glos. Glso 1yD-1995
11. Block, S.B. & Hirt, G.A. Foundations of Financial Management, Homewood, lllinois:
Richard D. lrwin, 1998.
12. John. J. Hampton Financial Decision Making Concepts Problems and Cases” Fourth Edition.
Prentice Hall of India. Private Limited. New Delhi, 1996.
13. Charles P. Jones. Introduction to Financial Management Richard D. Irwi Homewood,
lllinoive, 1992
14. Gitman, L.J “Principles of Managerial Finance, Fifth Edition, Harper Colling Publishers,
New York.
15. Brigham, E.F-Fundamentals of Financial Management Fifth Edition, the Drysen Press.