Financial management I, JJU, dept.

ACFN

UNIT 6: CAPITAL STRUCTURE AND LEVERAGE

6.1 INTRODUCTION
In unit 5 when we will calculate the weighted average cost of capital for use in capital budgeting, we
will take the capital structure weights, or the mix of securities the firm uses to finance its assets, as a
given. However, if the weights are changed, the calculated cost of capital and thus the set of
acceptable projects, also will change. Further changing the capital structure will affect the riskiness
of the firm common stock, and this will affect K s and Po. Therefore, the choice of a capital structure
is an important decision.

6.2 THE TARGET CAPITAL STRUCTURE

A firm analyzes a number of factors, and then it establishes a target capital structure. This target may
change over time as conditions vary, but at any given moment the firm’s management has a specific
capital structure in mind. If the actual debt ratio is become the target level, expansion capital will
probably be raised by issuing debt, whereas if the debt ratio is above the target, equity will probably
be used.
Capital structure policy involves a trade-off between risk and return:
 Using more debt raises the riskiness of the firm’s earnings stream
 However, a higher debt ratio generally leads to a higher expected rate of return
Higher risk tends to lower a stock’s price, but higher expected rate of return raises it. Therefore, the
optimal capital structure strikes a balance between risk and return so as to maximize a firm’s stock
price.
Four primary factors influence the capital structure decision
1. Business risk,
risk, or the risk inherent in the firm’s operations if it used no debt. The greater the
firm’s business risk, the lower its optimal debt ratio.
2. The firm’s tax position.
position. A major reason for using debt is that interest is deductible, which
lowers the effective cost of debt. However, if much of a firm’s income is already sheltered
from taxes by depreciation tax shields or tax loss carry-forwards, its tax ratio will be low, so
debt will not be as advantageous as it would be to a firm with a higher effective tax rate.
3. Financial flexibility,
flexibility, or the ability to raise capital on reasonable terms under adverse
conditions.
conditions. Corporate treasures know that a steady supply of capital is necessary for stable
operations, which is vital for long-run success. They also know that when money is tight in
the economy, or when a firm is experiencing operating difficulties, suppliers of capital prefer
to provide funds to companies with strong balance sheet. Therefore, both the potential further
need for funds and the consequences of a funds shortage have a major influence on the target
capital structure – the greater the probable future need for capital, and the worse the
consequences of a capital budget, the stronger the balance sheet should be.
4. Managerial conservatism or aggressiveness.
aggressiveness. Some managers are more aggressive than
others, hence some firms are more inclined to use debt in an effort to boost profits. This
factor does not affect, the optimal, or value- maximizing, capital structure, but it does
influence the target capital structure.
These four points larger determine the target capital structure, but operating conditions can cause the
actual capital structure to vary from the target.
 Financial management I, JJU, dept. ACFN

6.3 THE CONCEPT OF LEVERAGE

The leverage concept is very general. It is not unique to business or finance, and it can be used to
analyze many different types of problems. For example, other disciplines, such as economics and
engineering, use the same concept, and refer to it as elasticity. When used in a financial setting,
leverage measures the behavior of interrelated variables, such as output, revenue, earnings before
interest and taxes (EBIT), and earnings per share (EPS).
The material in this chapter will be easier to understand if two points are kept in mind.
1. Leverage measures the relationship between two variables, as opposed to measuring variables
independently, and the value that one variable assumes must depend on the values assume by
the second variable.
2. In order for leverage coefficients to have any useful applications, it must be possible to
identify which variable is the dependent variable. In other words, the direction of casualty
must be known. When two variables are so related, the degree of leverage describes the
responsiveness of the dependent variable to change in the independent variable.
Let Y and X represent two variables. When the values taken by Y are determined by the values taken
by X, Y is said to be dependent on X. accordingly, Y is called the dependent variable and X is
referred to as the independent variable. The algebraic statement of Y’s dependence on X is written
as:
Y = f (x)
And is read as: Y is a function of X
Suppose that the initial values of Y and X are known. The independent variable X now takes on a
new value. The change in the value of X and its percentage change are computed. The resulting
change and percentage change are also computed. Leveraged is then defined as the percentage
change in the dependent variable Y divided by the percentage change in the independent variable X.
in algebraic terms, the definition of leverage is developed as follows:
Let x = the change in the independent variable x
y = the change in the dependent variable y.
Δx
x = the percentage change in x = % x
Δy
y = the percentage change in y = % y
Then,
L ( y ) Δy / y
=
L ( x) Δx/ x
The left hand side of the above equation is read as: the leverage of y with respect to x.
6.3.1 Operating Leverage
Operating Leverage measures the relationship between output and earnings before interest and tax
(EBIT), specifically; it measures the effect of changing levels of output on EBIT. The functional
relationship between these two variables is:
y = f (T),
 Financial management I, JJU, dept. ACFN

Where, y = earning before interest and tax

T = number of units of output produced and sold

Earnings before interest and tax = Total revenue – Total variable cost – fixed cost.

When the level of output changes from its initial value, the initial value of EBIT also changes. Thus,
operating leverage is defined as the resulting percentage change in EBIT divided by the percentage
change in output, symbolically, operating leverage is expressed as:
L ( y) Δy / y % Δ EBIT
= =
L (T ) ΔT /T % Δ output

Example: Assume that the price per unit of output (p) is Br. 10, and variable cost per unit of output
(y) is Br. 4, and fixed cost (F) is Br. 30,000, and the level of output (T) is 8000 units. By using the
formula EBIT is computed as follows:
y = Total revenue – Total variable cost – fixed cost
y = TP – TV – F
or y = T (P – V) – F
y = 8000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 18,000

Now assume that the level of output increases from 8000 to 10,000 units. The resulting EBIT is
computed as:
y = 10,000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 30,000

The coefficient of operating leverage is computed as follows:

Percentage change in output = 2000/8000 = 25%
Percentage change in EBIT = Br. 12000/Br. 18000 = 66.7%
L( y ) Δy / y
=
L (T ) ΔT /T
L ( y) .667
=
L (T ) .25 = 2.67

The coefficient of operating leverage of 2.67 is interpreted as follows. A 1 percent change in output
from an initial value of 8000 units produces a 2.67 percent change in EBIT. Since output increased
by 25 percent from its initial value of 8000 units, EBIT increases by (2.67) (.25) = .667 or 66.7
percent.

Measurement equations equivalent to the definitional equations are used to compute and to explain
the properties of operating leverage. The measurement equation used when the income statement
relationship is describes as follows:
 Financial management I, JJU, dept. ACFN

T( P−V )
(OL/T) = T ( P−V ) − F

The left hand side of the equation is read as: operating leverage, given the value of output.

B1 putting the date of the previous example the above equation can be illustrated as follows:
8000 ( Br .10−Br . 4 )
= 2.67
(OL/T = 8000) = 8000 ( Br .10−Br . 4 )−30 ,000

Properties of Operating Leverage

The properties of operating leverage determine its use and a tool of financial analysis. These
properties are best explained by using operating breakeven and EBIT, operating breakeven is defined
as the value of output that makes EBIT equal to zero. At this level of output, total revenue is just
sufficient to pay operating variable and fixed costs, and no earnings are available to cover financial
costs, when output exceeds operating breakeven, the total revenue that is generated provides a
positive level of EBIT; below operating breakeven, the firm incurs an operating loss. The operating
breakeven is expressed as follows:

T (P – V) – F = 0
and solving for T yields
F
T= P−V
Example – Assume that P = Br. 25, V = Br. 10, and F = Br. 60,000. Operating breakeven is
calculated as follows:
Br .60 ,000
= 4000 units
T= Br.25 − Br.10
If operating leverage is calculated at operating breakeven, the coefficient of operating leverage would
be:
4000 ( Br.25−Br .10 )
=
4000 ( Br.25 − Br .10) − 60,000
Br.60,000
= = undefined
(OL/T = 4000) 0

Note that the coefficient of operating leverage at operating breakeven has undefined value, not a
value of zero.
 Financial management I, JJU, dept. ACFN

Interpretations of operating leverage

 Fundamental interpretation: - The percentage change in EBIT that results from a given
percentage change in output it equal to the value of operating leverage at the initial value of
output multiplied by the percentage change in output.
 Related interpretations: -
1- A positive coefficient of operating leverage indicates that the leverage is
being computed at a level of output greater than operating breakeven.
2- A negative coefficient of operating leverage indicates that leverage is being computed
at a level of output below operating breakeven
3- A large absolute value of operating leverage (the coefficient of operating leverage
without regard to its algebraic sing) indicates that output is close to operating breakeven
and that the absolute size of EBIT is relatively small
4- A positive coefficient of operating leverage close to 1.0 indicates that output is
relatively far above operating breakeven and that the amount of EBIT is relatively large.
5- If a high percentage of a firm’s total costs are fixed, the firm is said to have a high
degree of operating leverage.
6-A high degree of operating leverage, other things hold constant, means that a relatively
small change in sales will result in a large change in operating income.
6.3.2 Financial Leverage

Financial leverage measures the relationship between EBIT and earning per share (EPS).
Specifically, it reflects the effect of changing levels of EBIT on EPS. The functional relationship
between these two variables is:
EPS = f (EBIT)
and the income statement relationship is: -
Profit before taxes:
EBIT – interests on debt = Y – I
Federal income taxes:
(profit before taxes) (tax rate) = (Y – I) (t)
profit after tax:
profit before taxes – federal income taxes
(Y – I) – (Y – I) (t) or
(Y – I) (1 – t)
Earning available to common shareholders
profit after taxes – preferred stock dividends
(Y – I) (1 – t) – E
Earning per share of common stock:
Earning available to common shareholders
number of common shares issued
EPS = (Y – I) (1 – t) – E
N
 Financial management I, JJU, dept. ACFN

The algebraic equivalent of the complete income statement is obtained by substituting the symbolic
form of EBIT as follows:
[T ( P − V ) − F − I ] (1−t ) −E
EPS = N

When the level of EBIT changes from its initial value, the initial value of EPS also changes.
Financial leverage is thus defined as the resulting percentage change in EPS divided by the
percentage change in EBIT. Symbolically, financial leverage is expressed as:
L ( EPS ) Δ EPS /EPS % Δ EPS
= =
L (EBIT ) Δ EBIT /EBIT % Δ EBIT

Note that EBIT is the independent variable when measuring financial leverage, but the dependent
variable when measuring operating leverage. As a result, EBIT, is sometimes called the linking pin
variable with respect to leverage application in finance.

Example Assume that I = Br. 100,000, t = 0.4, E = Br. 80,000

N = 60,000, and EBIT = Br. 500,000. the EPS at this level of EBIT is
computed as:
EPS = (Br. 500,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 2.67

If EBIT increases from Br. 500,000 to Br. 600,000, the resulting EPS is:
EPS = (Br. 60,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 3.67

The financial leverage is computed as:

Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20%
Percentage change in EPS = Br. 1/Br. 2.67 = 37.45%
L ( EPS ) 0.3745
= = 1.87
L (EBIT ) 0.2

The coefficient of financial leverage of 1.87 is interpreted as follows: A 1 percent change in EBIT
from an initial value of Br. 500,000 produces a 1.87 percent change in EPS. Since EBIT increased by
20 percent from its initial value, EPS increased by 1.87 (0.20) = 0.374 or 37.4 percent.

The measurement equation used to compute the coefficient of financial leverage when the income
statement relationship is:
 Financial management I, JJU, dept. ACFN

Y
E
Y −I−
(FL/Y) = 1−t

The left hand side of the above equation is read as: financial leverage, given the value of EBIT.
By putting the data of the pervious example, equation is illustrated as:
500,000
= 1. 88
Br .80 ,000
Br. 500 , 000−Br .100 ,000−
(FL/Y = Br. 500,000) = 1 − 0. 4
Financial leverage is sometimes called balance sheet leverage or capital structure leverage.

Properties of financial leverage

The properties of financial leverage can be explained by using the concept of financial breakeven.
Financial breakeven is defined as the value of EBIT that makes EPS equal to zero. At financial
breakeven the firm’s EBIT, the form produces a positive level of earnings available to common
shareholders and a positive EPS. Below this level, profit available to common shareholders and EPS
are both negative. It is thus possible for a firm to earn a positive level of EBIT even though its EPS is
negative. This will happen when the firm’s EBIT is positive but less than its financial breakeven
level. Financial breakeven is expressed as:
(Y −I ) (1 − t )−E
=0
N
Solving this equation for Y, or EBIT, yields:
E
Y=I+ 1−t
Example – Assume I = Br. 2,000,000 and E = Br. 1,300,000. Financial breakeven is calculated as:
Assuming 40% tax rate.
Y = Br. 2,000,000 + Br. 1,300,000 / (1 – 0.4) = Br. 4,166,667

If financial leverage is calculated at financial breakeven, the resulting coefficient of financial

leverage has an undefined value, computing by using the above equation:
Br. 4 ,166,667
( FL/Y =Br. 4 ,166 ,667)=
Br. 4 ,166,667−Br. 2,000 ,000−Br .1, 300,000/(1−0.4 )
Br .4 , 166, 667
= = undefined
0

Interpretations of financial leverage

 Financial management I, JJU, dept. ACFN

 Fundamental interpretation: the coefficient of financial leverage is the percentage change in

EPS that results from a 1 percent change in EBIT.
 Related interpretations:
1. A positive coefficient of financial leverage means that leverage is being computed for a value
of EBIT that is greater than financial breakeven.
2. A negative coefficient of financial leverage indicates that leverage is being computed for a
value of EBIT below financial breakeven
3. A large absolute value of financial leverage indicates that leverage is being computed close to
financial breakeven and that the absolute value of EPS is relatively small.
4. A positive coefficient of financial leverage close to 1.0 indicates that leverage is being
computed for a value of EBIT that is relatively far above financial breakeven and that the
corresponding value to EPS is relatively large.
5. Financial leverage refers to the use of fixed-income securities-debt and preferred stock.

6.4 CAPITAL STRUCTURE THEORY

Capital structure theory has been developed along two main lines
- tax benefit bankruptcy cost trade-off theory
- signaling theory

Trade-off theory
Modern capital structure theory begins in 1958, when professors Franco Modigliani and Merton
Milles (hereafter MM) published what has been called the most influential article ever written. MM
proved, under a very restrictive set of assumptions, that because of the tax deductibility of interest on
debt, a firm’s value rises continuously as it uses more debt, and hence its value will be maximized by
financing almost entirely with debt. MM’s assumptions included the following:
1. There is no brokerage costs
2. There is no personal taxes
3. Investors can borrow as the same rate as corporations
4. Investors have the same information as management about the firm’s future investment
opportunities
5. All the firm’s debt is riskless, regardless of how much debt of uses
6. EBIT is not affected by the use of debt.

Since several of these assumptions were obviously unrealistic, MM’s positions was only the
beginning of capital structure research.

Subsequent researchers, and MM themselves, extended the basic theory by relaxing the assumptions.
Other researchers attempted to test the theoretical model with empirical data to see exactly how stock
prices and capital costs are affected by capital structure. Both the theoretical and empirical results
have added to our understanding of capital structure, but none of these studies has produced results
 Financial management I, JJU, dept. ACFN

that can be used to identify precisely a firm’s optimal capital structure. A summary of the theoretical
and empirical research are the following.
1. The fact that interest is deductible expense makes debt less expensive than common or
preferred stock. That is debt provides tax shelter benefits. As a result, using debt causes more
of the firm’s operating income (EBIT) to flow through to investors, so the more debt a
company uses, the higher its value and the higher the price of its stock.
2. The MM assumptions do not hold in the real world. First interest rate rises as the debt ratio
rises. Second, EBIT declines at extreme level of leverage. Third, expected tax rate fall at high
debt levels, and this reduces the expected value of the debt tax shelter. And, fourth, the
probability of the bankruptcy, which brings with it lawyers’ fee and other costs, increases as
the debt ratio rises.
3. Both theory and empirical evidence support the preceding discussion. However, statistical
problems prevent researchers from identifying points of threshold debt level where bankrupt
costs become material and optimal capital structure – where marginal tax shelter benefits and
marginal bankruptcy – related costs are equal.
4. Another disturbing aspect of capital structure theory is the fact that many large, successful
firms use far less debt then the theory suggests. This point led to the development of
signaling theory.

Signaling theory
MM assumed that investors have the same information about a firm’s prospects as its managers – this
is called symmetric information. However, managers often have better information than outside
investors. This is called asymmetric information, and it has an important effect on the optimal capital
structure. To see why, consider two situations, one in which the company’s managers know that its
prospects are extremely favorable (Firms F), and one in which the mangers know that the future
looks unfavorable (Firm U).

Suppose, for example, that Firm F’s have just discovered a nonpatentable cure for the common cold.
They want to keep the new product a secret as long as possible to delay competitors’ entry into the
market. New plant must be built to make the new product, so capital must be raised. How should
Firm F’s management raise the needed capital? If the firm sells stock, then, when profits from the
new product start flowing in, the price of stock will rise sharply, and the purchasers of the new stock
will have made a bonanza. The current stockholders (including the managers) will also do well, but
not as well as they would have done of the company had not sold sock before the price increased,
because then they would not have had to share the benefits of the new product with the new
stockholders. Therefore, one would expect a firm with very favorable prospects to try to avoid selling
stock and rather, to raise any required new capital by other means, including using debt beyond the
normal targest capital structure.

Now, let’s consider Firm U. suppose its managers have information that new orders are off sharply
because a competitor has installed new technology which has improved its products’ quality. Firm U
must upgrade its own facilities, at a high cost, just to maintain in recent sales level. As a result, in
 Financial management I, JJU, dept. ACFN

return on investment will fall (but not as much as if it took no action, which would lead to a 100
percent loss through bankruptcy). How should Firm U raise the needed capital? Here the situation is
just the reverse of that facing Firm F, which did not want to sell stock so as to avoid having to share
the benefits of future development. A firm with unfavorable prospects would want to sell stock,
which would mean bringing in new investors to share the losses.

The conclusion from all this is that firms with extremely bright prospect prefer not to finance through
new stock offerings, whereas firms with poor prospects do like to finance with outside equity. How
should you, as an investor, react to this conclusion?

6.5 FACTORS IN CAPITAL STRUCTURE DECISIONS

Firms generally should consider the following factors which influence capital structure decisions.
1. Sales stability: - A firm whose sales are relatively stable can safely take on more debt and incur
higher fixed charges than a company with unstable sales.
2. Asset structure: - Firms whose assets are suitable as security for loans tend to use rather heavily.
General purpose assets which can be used by many businesses make good collateral, whereas
special-purpose assets do not. Thus, real state companies are usually highly leveraged, whereas
companies involved in technological research employ less debt.
3. Operating leverage: - Other things the same, a firm with less operating leverage is better able to
employ financial leverage because, as we saw, the interaction of operating and financial leverage
determines the overall effect of a decline in sales on operating income and net cash flow.
4. Growth rate: - Other things the same, faster-growing firms must rely more heavily on external
capital.
5. Profitability: - One often observes, that firms with very high rates of return on investment use
relatively little debt. Although there is no theoretical justification for this fact, one practical
explanation is that very profitable firms simply do not need to do much debt financing. Their higher
rates of return enable them to do most of their financing with retained earnings.

6. Taxes: - Interest is a deductible expense, and deductions are most valuable to firms with high tax
rates. Hence, the higher a firm’s corporate tax, the greater the advantage of debt.
7. Control: - The effect of debt versus stock on management’s control position can influence capital
structure. If management currently has voting control (over 50 percent of the stock), but is not in a
position to buy any more stock, it may choose debt for new financing. One the other hand,
management may decide to use equity if the firm’s financial situation is so weak that he use of debt
might subject it to serious risk of default because, if the firms gores into default, the mangers will
almost surely lose their jobs.
8. Management attitudes: - Since no one can provide that one capital structure will lead to higher
stock prices than another, management can exercise its own judgment about the proper capital
structure. Some management tend to be more conservative than others, and thus use less debt than
the average firm in their industry, whereas aggressive management use more debt in the quest for
higher profits.
 Financial management I, JJU, dept. ACFN

9. Lender and rating agency attitude: - Regardless of mangers own analyses of this proper leverage
factors for their firms, lenders and rating agencies attitudes frequently influence financial structure
decisions. In the majority of the cases, the corporations discusses its capital structure with lenders
and rating agencies and gives much weight to their advice.
10. Market conditions: - Conditions in the stock and bond market undergo both long-and short-run
changes that can have an important bearing on a firm’s optimal capital structure.
11. The firm’s internal conditions: - A firm’s own internal condition can also have a bearing on its
target capital structure.
12. Financial flexibility: - maintaining financial flexibility, which from an operational view point,
means maintaining adequate reserve borrowing capacity. Determining an “adequate” reserve
borrowing capacity is judgmental, but it clearly depends on the factors mentioned previously in the
unit, including the firm forecasted need for funds, predicted capital market conditions, management’s
confidence in its forecasts, and the consequences on a capital shortage.

Exercises

1. GIZACEW Co. manufactures ladies; watch which are sold through discount houses. Each watch is
sold for Br. 25; and fixed costs are Br. 140,000 for 30,000 watches or less; variable costs are Br.
15 per watch
a. What is the firm’s gain or loss at sales of 8000 watches?
b. What is the company’s degree of operating leverage at sales of 8000 units? Of 1800 units?
c. What is the company’s degree of operating leverage at sales of 8000 units? Of 18000 units?
d. What happens to the breakeven point if the selling price rises to Br. 31? What is the
significance of the change to the financial manager?
e. What happens to the breakeven point of the selling rises to Br. 31 but variable costs rise to
Br. 23 unit?
2. TSEHAY Co., producer of turbine generators; is in this situation: EBIT = Br. 4 million; tax = T =
35%; debt outstanding = D = Br. 2 million; k d = 10%; ks = 15%; shares of stock outstanding = N o =
600,000; and book value per share = Br. 10. Since the company’s product market is stable and the
company expects no growth, all earnings are paid out as dividends. The debt consists of perpetual
bonds.
a. What are the earnings per share (EPS) and its price per share (Po)?
b. What is the weighted average cost of capital (WACC)?
c. The company can increase debt by Br. 8 million, to a total of Br. 10 million using the new
debt to buy back and retire some of its shares at the current price. Its interest rate on debt will
be 12 percent (it will have to call and refund the old debt), and its cost of equity will rise
from 15 percent to 17 percent. EBIT will remain constant, should the company change its
capital structure.
d. If the company did not have to refund the Br. 2 million of old debt, how would this affect
thing? Assume that the new and the still outstanding debt are equally risky, with k d = 12%,
but that the coupon rates on the old debt is 10 percent.
 Financial management I, JJU, dept. ACFN

3. ALEMU Co. produces Building materials which sell for p = Br. 100. Olinde’s fixed costs are Br.
200,000; 5000 components are produced and sold each year; EBIT is currently Br. 50,000; and the
assets (all equity financed) are Br. 500,000. The company estimates that it can change its production
process, adding Br. 400,000 to investment and Br. 50,000 to fixed operating costs. This change will
(1) Reduce variable cost per unit by Br. 10 and (2) increase output by 2000 units, but (3) the sales
price on all units will have to be lowered to Br. 95 to permit sales of the additional output. The
company uses no debt and its average cost of capital is 10 percent
a) Should the company make the change
b) Would the company degree of operating leverage increase or decrease if it made the
change? What about its breakeven point?
c) Suppose the company were unable to raise additional, equity financing and had to
borrow the Br. 400,000 to make the investment at an interest rate of 10 percent, use
the DU pont equation to find the expected ROA of the investment. Should the
company make the change if debt financing must be used