Chapter Five: Capital structure, Leverage and Long-term Financing Decisions

Introduction
Capital is the major part of all kinds of business activities, which are decided by the size, and
nature of the business concern. Capital may be raised with the help of various sources. If the
company maintains proper and adequate level of capital, it will earn high profit and they can
provide more dividends to its shareholders.
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. Capital Structure of a
company refers to the composition or make up of its capitalization and it includes all long-term
capital resources represented by debt, preferred stock, and common stock equity
The term capital structure refers to the relationship between the various long-term source
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.
The term financial structure is different from the capital structure. Financial structure shows the
pattern total financing. It measures the extent to which total funds are available to finance the
total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.
The following points indicate the difference between the financial structure and capital structure.
Financial Structures Capital Structures
1. It includes both long-term and short-term 1. It includes only the long-term sources of
sources of funds funds.
2. It means the entire liabilities side of the 2. It means only the long-term liabilities of
balance sheet. the company.
3. Financial structures consist of all sources of 3. It consist of equity, preference and
capital. retained earning capital.
4. It will not be more important while 4. It is one of the major determinations of
determining the value of the firm. the value of the firm.
Optimum Capital Structure
Optimum capital structure is the capital structure at which the weighted average cost of capital is
minimum and thereby the value of the firm is maximum. It may be defined as the capital
structure or combination of debt and equity, that leads to the maximum value of the firm.
Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.

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Forms of Capital Structure
Capital structure pattern varies from company to company and the availability of finance.
Normally the following forms of capital structure are popular in practice.
 Equity shares only.
 Equity and preference shares only.
 Equity and Debentures only.
 Equity shares, preference shares and debentures.
Factors Determining Capital Structure
The following factors are considered while deciding the capital structure of the firm.
Leverage
It is the basic and important factor, which affect the capital structure. It uses the fixed cost
financing such as debt, equity and preference share capital. It is closely related to the overall cost
of capital.
Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally
long- term finance such as equity and debt consist of fixed cost while mobilization. When the
cost of capital increases, value of the firm will also decrease. Hence the firm must take careful
steps to reduce the cost of capital.
a. Nature of the business: Use of fixed interest/dividend bearing finance depends upon the
nature of the business. If the business consists of long period of operation, it will apply
for equity than debt, and it will reduce the cost of capital.
b. Size of the company: It also affects the capital structure of a firm. If the firm belongs to
large scale, it can manage the financial requirements with the help of internal sources.
But if it is small size, they will go for external finance. It consists of high cost of capital.
c. Legal requirements: Legal requirements are also one of the considerations while
dividing the capital structure of a firm. For example, banking companies are restricted to
raise funds from some sources.
d. Requirement of investors: In order to collect funds from different type of investors, it
will be appropriate for the companies to issue different sources of securities.
Government policy
Promoter contribution is fixed by the company Act. It restricts to mobilize large, long-term funds
from external sources. Hence the company must consider government policy regarding the
capital structure.
Capital Structure Theories
Capital structure is the major part of the firm’s financial decision which affects the value of the
firm and it leads to change EBIT and market value of the shares. There is a relationship among
the capital structure, cost of capital and value of the firm. The aim of effective capital structure is
to maximize the value of the firm and to reduce the cost of capital. There are two major theories
explaining the relationship between capital structure, cost of capital and value of the firm.

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Traditional Approach
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach. According to the traditional approach, mix of debt and equity
capital can increase the value of the firm by reducing overall cost of capital up to certain level of
debt. Traditional approach states that the K o decreases only within the responsible limit of
financial leverage and when reaching the minimum level, it starts increasing with financial
leverage.
Assumptions
Capital structure theories are based on certain assumption to analysis in a single and convenient
manner:
 There are only two sources of funds used by a firm; debt and shares.
 The firm pays 100% of its earning as dividend.
 The total assets are given and do not change.
 The total finance remains constant.
 The operating profits (EBIT) are not expected to grow.
 The business risk remains constant.
 The firm has a perpetual life.
 The investors behave rationally.
Net Income (NI) Approach
According to this approach, the capital structure decision is relevant to the valuation of the firm.
In other words, a change in the capital structure leads to a corresponding change in the overall
cost of capital as well as the total value of the firm.
According to this approach, use more debt finance to reduce the overall cost of capital and
increase the value of firm. Net income approach is based on the following three important
assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
Net Operating Income (NOI) Approach
This is just the opposite to the Net Income approach. According to this approach, Capital
Structure decision is irrelevant to the valuation of the firm. The market value of the firm is not at
all affected by the capital structure changes.
According to this approach, the change in capital structure will not lead to any change in the total
value of the firm and market price of shares as well as the overall cost of capital.
NI approach is based on the following important assumptions;
 The overall cost of capital remains constant;
 There are no corporate taxes;
 The market capitalizes the value of the firm as a whole.
Modigliani and Miller Approach
Modigliani and Miller approach states that the financing decision of a firm does not affect the
market value of a firm in a perfect capital market. In other words MM approach maintains that

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the average cost of capital does not change with change in the debt weighted equity mix or
capital structures of the firm.
Modigliani and Miller approach is based on the following important assumptions:
 There is a perfect capital market.
 There are no retained earnings.
 There are no corporate taxes.
 The investors act rationally.
 The dividend payout ratio is 100%.
 The business consists of the same level of business risk.
Value of the firm can be calculated with the help of the following formula:
EBIT
V u= (1−T )
K0
Where
EBIT = Earnings before interest and tax
Ko = Overall cost of capital
T = Tax rate
Leverage
Financial decision is one of the integral and important parts of financial management in any kind
of business concern. A sound financial decision must consider the board coverage of the
financial mix (Capital Structure), total amount of capital (capitalization) and cost of capital (K o).
Capital structure is one of the significant things for the management, since it influences the debt
equity mix of the business concern, which affects the shareholder’s return and risk. Hence,
deciding the debt-equity mix plays a major role in the part of the value of the company and
market value of the shares. The debt equity mix of the company can be examined with the help
of leverage.
The concept of Leverage
Leverage and capital structure are closely related concepts that are linked to cost of capital and
therefore capital budget decision. Leverage results from the use of fixed cost assets or funds to
magnify returns to the firm’s owners. Changes in leverage result in changes in level of return and
associated risk. Generally, increases in leverage result in increased return and risk, whereas
decreases in leverage result in decreased return and risk. The amount of leverage in the firm’s
capital structure – the mix of long-term debt and equity maintained by the firm- can significantly
affect its value by affecting return and risk. Unlike some causes of risk, management has almost
complete control over the risk introduced through the use of leverage. The levels of fixed cost
assets and funds that management selects affect the variability of returns, that is, risk, which is
therefore controllable by management. Because of its effect on value, the financial manager must
understand how to measure and evaluate leverage, particularly when attempting to create the best
capital structure.
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,

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leverage measures the behavior of interrelated variables, such as output, revenue, EBIT, and
EPS.
Risk has been defined as the likely variability associated with expected revenue streams.
Focusing on the financial decision, the variations in the income stream can be attributed to: a) the
firm’s exposure to business risk and b) the firm’s decision to incur financial risk.
a. Business risk can be defined as the variability of the firm’s expected earnings before interest
and taxes (EBIT). It is measures by the firm’s corresponding expected coefficient of variation
(i.e., the larger the ratio, the more risk a firm is exposed to). Dispersion in operating income
does not cause business risk. It is the result of several influences, for example, the company’s
cost structure, product demand characteristics, and intra-industry competition. These
influences are a direct of the firm’s investment decision.
b. Financial risk is a direct result of the firm’s financing decision. When the firm is selecting
different financial alternatives, financial risk refers to the additional variability in earnings
available to the firm’s common shareholders and the additional chance of insolvency borne
by the common shareholder caused by the use o financial leverage. Financial leverage is the
financing of a portion of the firm’s assets with securities bearing a fixed (limited) rate of
return in hopes of increasing the ultimate return to the common shareholders. Financial risk
is to a large extent passed on to the common shareholders who must bear almost all of the
potential inconsistencies of returns to the firm after the deduction of fixed payment.
Break-Even Analysis
Breakeven analysis, which is sometimes called cost-volume profit analysis, is used by the firm:
1) to determine the level of operations necessary to cover all operating costs and 2) to evaluate
the profitability associated with various levels of sales. The firm’s operating breakeven point is
the level of sales necessary to cover all operating costs and financial costs. At the operating
breakeven point, EBIT equals $0. The first step in finding the operating breakeven point is to
divide the cost of goods sold and operating expenses into fixed and variable operating cost. Fixed
costs are a function of time, not sales volume, and are typically contractual; rent, depreciation,
insurance premiums, property taxes etc, are examples of fixed costs. Variable costs vary directly
with sales and are a function of volume, not time, shipping costs, direct labor, energy cost
associated with the production area, packaging, freight-out, sales commissions etc, are examples
of variable costs.
The Algebraic Approach
Using the following variables, we can represent the operating portion of the firm’s income
statement,
P = Sales price per unit
Q = Sales quantity in units
FC = Fixed operating cost per period
VC = Variable operating cost per unit
A formula for EBIT is written follows
EBIT = (P*Q) – FC –(VC*Q)
= Q * (P-VC) – FC

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At the breakeven point EBIT is equal to 0, so
FC
Q=
P−VC
EXAMPLE: The Wayne Company manufactures and sells doors to home builders. The doors are
sold for $25 each. Variable costs are $15 per door, and fixed operating costs total $50,000. The
company’s break-even point is:
FC $ 50,000
Q= = =5,000 doors
P−VC $ 25−15
Therefore, the company must sell 5,000 doors to break even.
Type of Leverage
The three basic types of leverage can best be defined with reference to the firm’s income
statement. In the general income statement format below, the portions related to the firm’s
operating, financial, and total leverage are clearly labeled.
General Income Statement Format and Types of Leverage
Sales revenue ............................................................................. XXXX
Less CGS .................................................................................. XXX
Gross Profit ............................................................................... XXX
Less operating expenses ............................................................. XXX
EBIT .......................................................................................... XXX
Less Interest ............................................................................... XXX
Net profit before taxes ................................................................ XXX
Less Taxes ................................................................................. XX
Net profit after taxes .................................................................. XXX
Less Preferred stock dividends .................................................... XX
Earnings available for common stockholders ................................ XX
Earnings per share (EPS) ............................................................. X

Types of Leverage
1. Operating Leverage
2. Financial Leverage
3. Total Leverage

Operating leverage (OL) is concerned with the relationship b/n the firm’s sales revenue and it’s
EBIT (Operating profit). Operating leverage results from the existence of fixed operating costs in
the firm’s income stream. We can define operating leverage as the potential use of fixed
operating costs to magnify the effects of changes in sales on the firm’s EBIT. Operating leverage
occurs any time a firm has fixed costs. In other words, with fixed operating costs, the percentage
change in profits accompanying a change in volume is greater than the percentage change in
volume.
If a high percentage of total costs are fixed, then the firm has a high degree of operating leverage,
which, with other factors held constant, implies that a relatively small change in sales results in a

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large change in return on equity. Therefore, the higher the operating leverages, the higher the
business risk.

Operating leverage can be calculated with the help of the following formula:
C
OL=
OP
Where,
OL = Operating Leverage
C = Contribution
OP = Operating Profits
Measuring the Degree of Operating Leverage (DOL)
The degree of operating leverage (DOL) is the numerical measure of the firm’s operating
leverage. It can be derived by using the following equation.

Percentage change ∈ EBIT

DOL=
Percentage change ∈Sales
or
%age change∈operating income=%age increase∈sales X Degree of operating leverage

The degree of operating leverage also depends on the base level of sales used as a point of
reference. The closer the base sales level used is to the operating breakeven point, the greater the
operating leverage. Comparison of the DOL of two firms is valid only when the base level of
sales used for each firm is the same
EXAMPLE: The Wayne Company manufactures and sells doors to home builders. The doors
are sold for $25 each. Variable costs are $15 per door, and fixed operating costs total $50,000.
Assume that the Wayne Company is currently selling 6,000 doors per year. Its operating leverage
is:
C ( P−V ) Q ( 25−15 ) 6,000 60,000
OL= = = = =6
OP ( P−V ) Q−FC ( 25−15 ) 6,000−50,000 10,000
Which means if sales increase by 10 percent, the company can expect its operating income to
increase by six times that amount, or 60 percent.
Means if sales increases by 10%, operating income increases as:

%age change∈operating income=%age increase∈sales X Degree of operating leverage

%age change∈operating income=10 % X 6=60 %
Fixed costs and operating leverage
Changes in fixed operating costs affect operating leverage significantly. Firms can sometimes
incur fixed operating costs rather than variable operating costs and at other times may be able to
substitute one type of cost for the other. For example, a firm could make fixed-dollar lease
payments rather than payments equal to a specified percentage of sales, or it could compensate
sales representatives with a fixed salary and bonus rather than on a pure percent-of-sales
commission basis.

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Financial Leverage (FL) is concerned with the relationship b/n the firm’s EBIT and its common
stock earnings per share (EPS). FL results from the presence of fixed financial costs in the firm’s
income stream. Financial leverage can be defined as potential use of fixed financial costs to
magnify the effect of changes in EBIT on the firm’s EPS. The two financial costs that may be
found in the firm’s income statement are interest on debt and preferred stock dividends. These
charges must be paid regardless of the amount of EBIT available to pay them.
Although preferred stock dividends can be “Passed” (not paid) at the option of the firm’s
directors, it is generally believed that the payment of such dividends is necessary. Therefore the
preferred stock dividends if it were contractual obligations, not only to be paid as fixed amount,
but also to be paid as scheduled. Although failure to pay preferred dividends cannot force the
firm in to bankruptcy, it increases the common stockholders’ risk b/c they cannot be paid
dividends until the claims of preferred stockholders are satisfied.
( P−V ) Q−FC
FL at givenlevel of sale(x )=
( P−V ) Q−FC −IC
Where EPS is earnings per share, and IC is fixed finance charges, i.e., interest expense or
preferred stock dividends. [Preferred stock dividend must be adjusted for taxes i.e., preferred
stock dividend/(1 - T).]
Measuring the Degree OF Financial Leverage (DFL)
The DFL is the numerical measures of the firm’s financial leverage. DFL also called the
coefficient of FL is the percentage change in EPS (dependent variable) that results from a given
percentage change in EBIT (independent variable).
Percentage change∈ EBIT
DFL at given level of sale (x)=
Percentage change ∈ EPS
This approach is valid only when the base level of EBIT used to calculate and compare these
values is the same. In other words, the base level of EBIT must be held constant to compare the
financial leverage associated with different levels of fixed financial costs.
EXAMPLE: The Wayne Company manufactures and sells doors to home builders. The doors
are sold for $25 each. Variable costs are $15 per door, and fixed operating costs total $50,000.
Assume that the Wayne Company is currently selling 6,000 doors per year. The Wayne
Company has total financial charges of $2,000, half in interest expense and half in preferred
stock dividend. The corporate tax rate is 40 percent. What is their financial leverage?
1,000
First, IC=1,000+ =1,000+1,667=2,667
1−0.4
Therefore, Wayne’s financial leverage is computed as follows:

( P−V ) Q−FC ( 25−15 ) 6,000−50,000

FL at givenlevel of sale ( x )= =
( P−V ) Q−FC −IC ( 25−15 ) 6,000−50,000−2,667
¿ 1.36
Which means that if EBIT increases by 10 percent, Wayne can expect its EPS to increase by 1.36
times, or by 13.6 percent.

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Total Leverage (TL) is concerned with the relationship between the firm’s sales revenue and
earnings per share (EPS). The combined effect of operating and financial leverage on the firm’s
risk can be assessed by using a framework similar to that used to develop the individual concepts
of leverage. This 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
earning per share (EPS). Total leverage can therefore be viewed as the total impact of the fixed
costs in the firm’s operating and financial structure.
Total leverage at a given level of sales(x)

( P−V ) Q
∗( P−V ) Q−FC
( P−V ) Q−FC
CL=
( P−V ) Q−FC −IC

( P−V ) Q
CL=
( P−V ) Q−FC −IC

CL=Operating Leverage∗Financial Leverage

Measuring the Degree of Total Leverage (DTL)

The DTL is the numerical measure of the firm’s total leverage. It can be obtained in a fashion
similar to that used to measure operating and financial leverage.
Percentage change ∈EBT
DCL=
Percentage change∈ EBIT
This approach is valid only when the base level of sales used to calculate and compare these
values is the same. In other words, the base level of sales must be held constant to compare the
total leverage associated with different levels of fixed costs.
EXAMPLE: The Wayne Company manufactures and sells doors to home builders. The doors
are sold for $25 each. Variable costs are $15 per door, and fixed operating costs total $50,000.
Assume that the Wayne Company is currently selling 6,000 doors per year. The Wayne
Company has total financial charges of $2,000, half in interest expense and half in preferred
stock dividend. The corporate tax rate is 40 percent. What is the total leverage?
( P−V ) Q ( 25−15 ) 6,000
CL= =
( P−V ) Q−FC −IC ( 25−15 ) 6,000−50,000−2,667
60,000
CL= =8.18
7,333
CL=Operating Leverage∗Financial Leverage
CL=6∗1.36=8.16
1. Maraki Corporation has a capital structure that consists of 70% common stock and 30% debt.
The company’s long-term bonds have a before-tax yield to maturity of 8.4%. Maraki’s
common stock currently trades at Br 45 per share. The year-end dividend is expected to be Br
2.50 per share, and the dividend is expected to grow forever at a constant rate of 7% a year.
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The flotation cost associated with issuing new common stock is 10%. The company’s tax rate
is 40%.

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