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Capital Structure and Leverages

The document discusses capital structure and leverage. It defines capital structure as long-term debt plus equity. It also discusses optimal capital structure, factors that determine it, and approaches to determining it such as EBIT-EPS and valuation approaches. The document also defines operating leverage as the ability of fixed costs to magnify changes in sales, and financial leverage as the ability of fixed financial charges to magnify changes in operating profit. It discusses combining operating and financial leverage and their effects on earnings per share.

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69 views13 pages

Capital Structure and Leverages

The document discusses capital structure and leverage. It defines capital structure as long-term debt plus equity. It also discusses optimal capital structure, factors that determine it, and approaches to determining it such as EBIT-EPS and valuation approaches. The document also defines operating leverage as the ability of fixed costs to magnify changes in sales, and financial leverage as the ability of fixed financial charges to magnify changes in operating profit. It discusses combining operating and financial leverage and their effects on earnings per share.

Uploaded by

bansalparth
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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CAPITAL STRUCTURE

AND LEVERAGES
LEARNING OBJECTIVES
• Give meaning of Capital Structure
• Distinguish between capital structure and financial structure
• Know the optimum capital structure
• Highlight the features of appropriate capital structure
• Discuss factors that determine a firm’s capital structure
• List out the forms of capital structure
• Know importance of EBIT-EPS analysis in establishing optimal
capital structure
• Say the meaning of point of indifference
• Know the meaning and types of leverages
• Calculate operating leverage and break-even quantity
• Calculate financial leverage and its impact on EPS
• Know appropriate combination of operating and financial
leverage
Meaning of Capital Structure

• Capital Structure: Include only long-term debt and total


stockholder investment
Capital Structure = Long-term Debt + Preferred Stock + Net
worth (or)
Capital Structure = Total Assets – Current Liabilities
Optimum Capital structure
Optimum Capital Structure: The level of debt equity
proportion where market value of share is maximum, and cost
of capital is minimum
Features:
• Profitability
• Solvency
• Flexibility
• Conservatism
• Control
Determinants of Capital structure
Patterns of Capital Structure
1. Complete equity share capital;
2. Different proportions of equity and preference share capital;
3. Different proportions of equity and debenture (debt) capital an
4. Different proportions of equity, preference and debenture (debt) capital.
Approaches in Determining Optimum
Capital Structure

1. EBI T – EPS Approach: This approach is helpful to


analyse the impact of debt on earnings per share.
2. Valuation Approach: It determines the impact of use
of debt on the shareholders value and
3. Cash Flow Approach: It analyses the firm’s debt
service capacity.
Indifferent point
• Point of Indifference: The level of EBIT at which EPs is
same for two alternative capital structures

(X – I1) (1 – t) – PD (1 + Dt) (X – I2) (1 – t) – PD (1 + Dt)


=
ES1 ES2
Where: X = EBIT
I1,I2 = Interest under alternatives 1 and 2
t = Tax rate
PD = Preference dividend
Dt = Preference dividend tax
ES1, ES2 = No. of equity share outstanding under alternative 1 and 2
Leverage

• Leverage: The action of a lever and mathematical advantage


gained by it
Types of Leverages
• Operating leverage
• Financial leverage
Operating Leverage
• Operating Leverage: The firm’s ability to use operating
cost to magnify the effects of changes in sales on its EBIT
Degree of Operating Leverage Percentage change in EBIT
= Or
(DOL) Percentage change in Sales

When the data is given only for one year, then we


have to compute operating leverage, by the following
formula.

Operating Contribution
=
Leverage
Operating Profit (EBIT)
Financial Leverage
• Financial Leverage: Ability of the firm to use fixed financial charges
to magnify the effect of changes in EBIT on firm’s EPS

  EBIT (Operating profit)  


Financial
= Or
Leverage EBT (Taxable income)
   

Percentage change in EPS


Degree of Financial Leverage
=
(DFL) Percentage change in EBIT
Combined Leverage
• Combined leverage: The percentage change in EPS due to the
percentage change in sales

% Change in EBIT % Change in EPS % Change in EPS


=
% Change in Sales X % Change in EBIT % Change in Sales

Or

EBIT Contribution
Contribution X =
EBIT EBT EBT
Effect of Leverage on Firm

Operating Financial
Combined Effect
Leverage Leverage
High High This combination is very dangerous policy, which should
be avoided.
Low Low This combination is very cautious policy and not
assuming risk.
High Low This combination have adverse effects of operating
leverage were taken care of by having low financial
leverage.
Low High This combination is an ideal situation. The company can
follow aggressive debt policy.

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