CHAPTER ONE
1. CAPITAL STRUCTURE AND LEVERAGE
1.1. Meaning of Capital Structure
Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares,
preference shares, debentures, long-term loans and retained earnings. The term capital structure
refers to the relationship between the various long-term sources of financing such as equity
capital, preference share capital and debt capital. Deciding the suitable capital structure is the
important decision of the financial management because it is closely related to the value of the
firm. Capital structure is the permanent financing of the company represented primarily by long
term debt and equity.
1.2. Factors that Influence Capital Structure Decision
Four primary factors influence capital structure decisions.
Business risk (the riskiness inherent in the firm’s operations if it used no debt): The
greater the firm’s business risk, the lower its optimal debt ratio.
The firm’s tax position.
Financial flexibility (the ability to raise capital on reasonable terms under adverse
conditions).
Managerial conservatism or aggressiveness: This factor does not affect the true optimal,
or value-maximizing, capital structure, but it does influence the manager determined
target capital structure.
1.3. Business and Financial Risk
1.3.1. Business Risk and Operating Leverage
Business risk is the possibility of a commercial business making inadequate profits
due to uncertainties. Business risk depends on a number of factors, the more important of which
are listed below:
Demand variability. The more stable the demand for a firm’s products, other things held
constant, the lower its business risk.
Sales price variability. Firms whose products are sold in highly volatile markets are
exposed to more business risk than similar firms whose output prices are more stable.
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Input cost variability. Firms whose input costs are highly uncertain are exposed to a high
degree of business risk.
Ability to adjust output prices for changes in input costs. Some firms are better able than
others to raise their own output prices when input costs rise. The greater the ability to
adjust output prices to reflect cost conditions, the lower the degree of business risk.
Ability to develop new products in a timely, cost-effective manner. Firms in such high-
tech industries as drugs and computers depend on a constant stream of new products. The
faster its products become obsolete, the greater a firm’s business risks.
Foreign risk exposure. Firms that generate a high percentage of their earnings overseas
are subject to earnings declines due to exchange rate fluctuations. Also, if a firm operates
in a politically unstable area, it may be subject to political risks.
The extent to which costs are fixed: operating leverage. If a high percentage of costs are
fixed, hence do not decline when demand falls, then the firm is exposed to a relatively
high degree of business risk.
Operating leverage is concerned with the relationship between the firm’s sales revenue and its
earnings before interest and taxes (EBIT) or operating profits. It is the use of fixed operating
costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes.
The degree of operating leverage (DOL) is the numerical measure of the firm’s
operating leverage.
OR
As long as DOL is greater than 1, there is operating leverage
1.3.2. Financial Risk and Financial Leverage
Financial risk is the type of danger that can result in the loss of capital to interested parties.
Financial leverage is the use of fixed financial costs to magnify the effects of changes in
earnings before interest and taxes on the firm’s earnings per share. The two most common fixed
financial costs are (1) interest on debt and (2) preferred stock dividends. The degree of financial
leverage (DFL) is the numerical measure of the firm’s financial leverage. Whenever DFL is
greater than 1, there is financial leverage.
Total Leverage
We also can assess the combined effect of operating and financial leverage on the firm’s risk by
using a framework similar to that used to develop the individual concepts of leverage. This
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combined effect, or total leverage, can be defined as the potential use of fixed costs,
both operating and financial, to magnify the effect of changes in sales on the firm’s earnings per
share. Total leverage can therefore be viewed as the total impact of the fixed costs in the firm’s
operating and financial structure.
1.4. Determining the Optimal Capital Structure
What, then, is an optimal capital structure, even if it exists (so far) only in theory? Generally
speaking the optimal capital structure is considered to be that which minimizes the weighted
average cost of capital, WACC, and consequently maximizes the value of the firm. It is generally
believed that the value of the firm is maximized when the cost of capital is minimized. By using
a modification of the simple zero-growth valuation model, we can define the value of the firm.
1.4.1. EBIT‐EPS Analysis
EBIT‐EPS analysis gives a scientific basis for comparison among various financial plans and
shows ways to maximize EPS. Hence EBIT‐EPS analysis may be defined as ‘a tool of financial
planning that evaluates various alternatives of financing a project under varying levels of EBIT
and suggests the best alternative having highest EPS and determines the most profitable level of
EBIT’. Various advantages derived from EBIT‐EPS analysis may be enumerated below:
Financial Planning
Comparative Analysis
Performance Evaluation
Determining Optimum Mix
Illustration
A Ltd. Has a share capital of br. 100,000 divided into share of br. 10 each. It has a major
expansion program requiring an investment of another br. 50,000. The Management
is considering the following alternatives for raising this amount:
i. Issue of 5,000 equity shares of br. 10 each
ii. Issue of 5000, 12% preference shares of br. 10 each
iii. Issue of 10% debentures of br. 50,000
iv. Issue of 2,000 equity shares of br. 10 each, issue of 2000, 12% preference shares of br. 10
each and Issue of 10% debentures of br. 10,000
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The company’s present Earnings before Interest and Tax (EBIT) are br. 40,000 per
annum subject to tax @ 50%. You are required to calculate the effect of the above financial plan
on the earnings per share presuming:
(a) EBIT continues to be the same even after expansion
(b) EBIT increases by br. 10,000
Solution
(a) When EBIT is br. 40,000 Per Annum
Projected Earnings per Share
1.5. Introduction to the Theory of Capital Structure
1.5.1. Modigliani and Miller (M M) Theory
[Link]. MM Theory with No Taxes
M&M proposed that the value of a firm is independent of its cost of capital and its capital
structure. MM’s study was based on some strong assumptions:
There are no brokerage costs.
There are no taxes.
There are no bankruptcy costs.
Investors can borrow at the same rate as corporations.
All investors have the same information as management about the firm’s
future investment opportunities.
EBIT is not affected by the use of debt.
Modigliani and Miller imagined two hypothetical portfolios.
a) The first portfolio contains all the equity of an unlevered firm, so the portfolio’s value is Vu.
Because the firm has no growth (it does not need to invest in any new net assets) and pays no
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taxes, the firm can payout all of its EBIT in the form of dividends. Therefore, Cash flow
from owning this first portfolio is equal to EBIT.
b) The second portfolio contains all of the levered firm’s stock (SL) and debt (D), so the
portfolio’s value is VL. If the interest rate is rd, then the levered firm pays out interest in the
amount rdD. Because the firm is not growing and pays no taxes, it can pay out dividends
in the amount EBIT − rdD. If you owned all of the firm’s debt and equity: The cash flow
would be equal to the sum of interest & dividends:
rdD + (EBIT − rdD) = EBIT.
Thus, the cash flow of each portfolio is equal to EBIT.
MM concluded that two portfolios producing the same cash flows must have the same value:
VL = SL + D = VU
MM proved that a firm’s value is unaffected by its capital structure.
MM Theory with Corporate Taxes
In 1963, MM relaxed the assumption that there are no corporate taxes. The Tax Code allows
corporations to deduct interest payments as an expense, but dividend payments to stockholders
are not deductible. The differential treatment encourages corporations to use debt in their capital
structures. The tax deductibility of the interest payments shields the firm’s pre-tax income. The
value of a levered firm is value of an identical unlevered firm plus value of any “side effects.”
VL = VU + Value of side effects = VU + PV of tax shield
Present value of the tax shield is equal to the corporate tax rate, T, multiplied by the amount of
debt, D:
VL = VU + TD
As a result, under MM with corporate taxes, the WACC falls as debt is added.
1.5.2. Trade-off Theory
The tradeoff theory of leverage argues that firms trade off the benefits of debt
financing (favorable corporate tax treatment) against the higher interest rates and bankruptcy
costs. The fact that interest is a deductible expense makes debt less expensive than common or
preferred stock. In effect, the government pays part of the cost of debt capital, or, to put it
another way, debt provides tax shelter benefits. As a result, using debt causes more of the firm’s
operating income (EBIT) to flow through to investors. Therefore, the more debt a company uses,
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the higher its value and stock price. At low leverage levels, tax benefits outweigh bankruptcy
costs, and at high levels, bankruptcy costs outweigh tax benefits.
VL = VU + PV tax shied – Financial distress costs
1.5.3. Signaling Theory
Managers use issues of debt and equity to signal information about a firm’s future prospects to
less informed owners and investors. Issuing debt would be interpreted as a positive signal about
the company’s future. In contrast, the decision to issue equity would generally be interpreted by
shareholders and investors as a negative signal.
1.6. Using Debt Financing to Constrain Managers
Agency problems may arise if managers and shareholders have different objectives.
Such conflicts are particularly likely when the firm's managers have too much cash at their
disposal. Managers often use excess cash to finance pet projects or for perquisites such as nicer
offices, corporate jets, and sky boxes at sports arenas, all of which may do little to maximize
stock prices. Managers with limited "excess cash flow" are less able to make wasteful
expenditures.
Firms can reduce excess cash flow in a variety of ways. One way is to funnel some of it back to
shareholders through higher dividends or stock repurchases. Another alternative is to shift the
capital structure toward more debt in the hope that higher debt service requirements will force
managers to be more disciplined. If debt is not serviced as required, the firm will be forced into
bankruptcy, in which case its managers would likely lose their jobs.
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