Capital Structure and

Leverage

Dr.Maduranga Kulathunga
Senior Lecturer
Faculty of Management
 Background
• Capital structure refers to the mix of a firm’s
debt and equity
– Preferred stock is assumed to be part of a firm’s
debt
• Financial leverage refers to using borrowed
money to enhance the effectiveness of
invested equity
• Financial leverage of 10% means the firm’s
capital structure contains 10% debt and 90%
equity
 The Central Issue
• Can the use of debt increase the value of a
firm’s equity
– Specifically, the firm’s stock price
• Under certain conditions changing leverage
increases stock price
– An optimal capital structure maximizes stock price
• The relationship between capital structure
and stock price is not precise nor fully
understood
 Risk in the Context of Leverage
• Leverage influences stock price
– Alters the risk/return relationship in an equity investment
• Measures of performance
– Operating income ( EBIT or Earnings Before Interest and
Taxes)
• Unaffected by leverage because it is calculated prior to the
deduction for interest
– Return on Equity (ROE) is Earnings after Taxes 
Stockholders’ Equity
– Earnings per Share (EPS) is Earnings after Taxes  number
of shares
• Investors regard EPS as an important indicator of future
profitability
 Risk in the Context of Leverage
• Redefining Risk for Leverage-Related
Issues
– Leverage-related risk is variation in ROE and
EPS
• Business risk—variation in EBIT
• Financial risk—additional variation in ROE and
EPS brought about by financial leverage
Figure 1: Business and Financial Risk
 Operating Leverage and Risk

• Relates to a company’s cost structure

– Involves relative use of fixed and variable costs
• Operating leverage has an influence on a
firm’s business risk
 Financial Leverage
• Under certain conditions financial leverage
can improve a firm’s ROE and EPS
– However, at other times it may worsen EPS and
ROE
Table 1

As the firm’s debt

ratio rises, both
EPS and ROE rise
dramatically. While
EAT falls, the
number of shares
outstanding falls at
a faster rate as
debt replaces
equity.
 Financial Leverage
• Return on Capital Employed (ROCE)
– Measures the profitability of operations before financing charges but
after taxes on a basis comparable to ROE

EBIT (1 - tax rate)

ROCE =
debt + equity

◼ When the ROCE exceeds the after-tax cost of debt,

more leverage improves ROE and EPS
◼ When ROCE is less than the after-tax cost of debt,
more leverage makes ROE and EPS worse
Table 2

ABC is now
doing rather
poorly—ROE and
ROCE are quite
low. As the firm
adds leverage,
EPS and ROE
decrease.
 Financial Leverage—Example
Q: Selected financial information for the Albany Corporation follows:

Albany Corporation at $10M Debt

($000 except for per-share amounts)

EBIT $23,700 Debt $10,000

Interest (@12%) 1,200 Equity 90,000
EBT $22,500 Capital $100,000
Tax (@40%) 9,000 Number of shares= 900,000
EAT $13,500
Stock price = $10 per share
ROE = EAT  equity = $13,500  $90,000 = 15%
EPS = EAT  number of shares = $13,500  900,000 = $1.50

The treasurer feels debt can be traded for equity without immediately affecting the price of the stock or
the rate at which the firm can borrow. Management believes it is in the best interest of the company and
its stockholders to move the firm’s EPS from its current level up to $2.00 per share. However, no
opportunities are available to increase operating profit (EBIT) above the current level of $23.7 million.
Will borrow more money and retiring stock raise Albany’s EPS, and if so what capital structure will
achieve an EPS of $2.00?
 Financial Leverage—Example
A: EPS will rise if ROCE exceeds the after-tax cost of debt. ROCE is currently:
23.7M (1 - 0.40 )
ROCE = = 14.2%
$100.0M
The after-tax cost of debt is 12% x (1 – 0.4), or 7.2%. Since 7.2% <
14.2%, trading equity for debt will increase EPS.
Using trial and error, you can determine that $45 million of debt is the
approximate amount of debt that makes the firm’s EPS equal $2.00.
 An Alternate Approach
• Using ratios and information from financial
statements we can solve for unknown values
• EPS = ROE × Book Value per share
• ROE = EAT ÷ Equity
• EAT = [EBIT – Interest] (1 – tax rate)
• Interest = kd (Debt)
– Therefore, EAT = [EBIT – (kd)(Debt)](1 – tax rate)
• Equity = Total Capital – Debt
• EPS = [[EBIT – (kd)(Debt)](1 – tax rate)] ÷ Total Capital
– Debt
 An Alternate Approach

• Using the previous example everything is known

except Debt
• If we set EPS to $2 we can solve for the value of Debt

$2 =
$23.7M - (.12)(Debt)(1- .4)
$10 
$100.0M - Debt
Debt = $45,156,25 0
 Financial Leverage and Financial Risk

• Financial leverage is a two-edged sword

– Multiplies good results into great results
– Multiples bad results into terrible results
• ROE and EPS for leveraged firms experience
more variation
• Financial risk is the increased variability in
financial results that comes from additional
leverage
 Putting the Ideas Together—The
Effect on Stock Price
• Leverage enhances performance while it adds
risk, pushing stock prices in opposite
directions
– Enhanced performance makes the expected
return on stock higher, driving up the stock’s price
– The increased risk drives down the stock’s price

Which effect dominates, and when?

 Real Investor Behavior and the
Optimal Capital Structure
• When leverage is low an increase in debt has a
positive effect on investors
• At high debt levels concerns about risk
dominate and adding more debt decreases
the stock’s price
• As leverage increase its effect goes from
positive to negative, which results in an
optimum capital structure
Figure 2: The Effect of Leverage
on Stock Price
 Finding the Optimum—A Practical
Problem
• There is no way to determine the exact optimum
amount of leverage for a particular company at a
particular time
– Appropriate level tends to vary according to
• Nature of a company’s business
– If firm has high business risk it should use less leverage
• Economic climate
– If the outlook is poor investors are likely to be more sensitive to risk

• As a practical matter the optimum capital structure

cannot be precisely located
 The Target Capital Structure
• A firm’s target capital structure is
management’s estimate of the optimal capital
structure
– An approximation or best guess as to the amount
of debt that will maximize the firm’s stock price
 The Effect of Leverage When Stocks
Aren’t Trading at Book Value
• We’ve assumed that changes in leverage
involve purchasing equity at book value
• If this is not the case, things are more
complex
– Repurchasing stock at prices other than
book value will have the same general
impact on ROE, but not necessarily for EPS
• However the important point is the direction of
the stock price change, not the exact amount
 The Degree of Financial Leverage
(DFL)—A Measurement
• Financial leverage magnifies changes in EBIT into
larger changes in ROE and EPS
– The degree of financial leverage (DFL) relates relative
changes in EBIT to relative changes in EPS
%  EPS Somewhat
DFL = or %  EPS = DFL  %  EBIT
%  EBIT tedious

◼ An easier method of calculating DFL is:

EBIT
DFL =
EBIT - Interest
 The Degree of Financial Leverage
(DFL)—A Measurement—Example
Q: Selected income statement and capital information for the Moberly Manufacturing Company follow
($000):

Capital
Revenue $5,580 Debt $1,000
Cost/expense 4,200 Equity 7,000
EBIT $1,380 Total $8,000

Currently 700,000 shares of common stock are outstanding. The firm pays 15% interest on its debt
and anticipates that it can borrow as much as it reasonably needs at that rate. The income tax rate is
40%

Moberly is interested in boosting the price of its stock. To do that management is considering
restructuring capital to 50% debt in the hope that the increased EPS will have a positive effect on price.
However, the economic outlook is shaky, and the company’s CFO thinks there’s a good chance that a
deterioration in business conditions will reduce EBIT next year. At the moment Moberly’s stock sells for
its book value of $10 per share.
Estimate the effect of the proposed restructuring on EPS. Then use the degree of financial leverage to
assess the increase in risk that will come along with it.
 The Degree of Financial Leverage
(DFL)—A Measurement (Example)
A: Since the equity is trading at book value, this is a relatively simple example.

Current Proposed
Capital
Debt $1,000 $4,000
Equity 7,000 4,000
Total $8,000 $8,000
Shares outstanding 700,000 400,000

Current Proposed
EBIT $1,380 $1,380
Interest (15% of debt) 150 600 If business conditions
EBT $1,230 $780 remain unchanged, a
Tax (@40%) 492 312 higher EPS will result
EAT $738 $468 with the addition of debt.
EPS $1.054 $1.170
 The Degree of Financial Leverage
(DFL)—A Measurement—Example
A: Next, calculate DFL:
$1,380
DFL Current = = 1.12
$1,380 - $150
$1,380
DFL Proposed = = 1.77
$1,380 - $600

EPS will be much more volatile under the proposed plan. EPS will
change by a factor of 1.77 vs. 1.12.
 EBIT-EPS Analysis
• Managers need a way to quantify and analyze the
tradeoffs between risk and results when changing
leverage levels
• Provides a graphical portrayal of the trade-off
– Involves graphing EPS as a function of EBIT for each
leverage level
• Portrays the results of leverage and helps to decide
how much to use
 Figure 3: EBIT – EPS Analysis for ABC
Corporation

It is
important to
determine When examining the ABC
the Corporation you can see that
indifference the 50% Debt and No
point, which Leverage lines intersect. At
occurs when the point of intersection ABC
the two is indifferent between the two
plans offer plans. However, to the left of
the same the intersection the 50% Debt
EBIT. plan is preferable, but to the
right of the point the No
Leverage plan is preferable.
 Operating Leverage
• Terminology and Definitions
– Risk in Operations—Business Risk
• Variation in EBIT
– Fixed and Variable Costs and Cost Structure
• Fixed costs don’t change with the level of sales, while variable
costs do
– Fixed costs include rent, depreciation, utilities, salaries
– Variable costs include direct labor, direct materials, sales
commissions
• The mix of fixed and variable costs in a firm’s operations is its cost
structure
– Operating Leverage
• Refers to the amount of fixed costs in the cost structure
 Breakeven Analysis
• Used to determine the level of activity a firm
must achieve to stay in business in the long
run
• Shows the mix of fixed and variable cost and
the volume required for zero profit/loss
– Profit/loss generally measured by EBIT
 Breakeven Analysis
• Breakeven Diagrams
– Breakeven occurs at the intersection of revenue
and total cost
• Represents the level of sales at which revenue equals
cost
Figure 5: The Breakeven Diagram
 Breakeven Analysis
• The Contribution Margin
– Every sale makes a contribution of the difference
between price (P) and variable cost (V)
• Ct = P – V
– Can be expressed as a percentage of revenue
• Known as the contribution margin (CM)
• CM = (P – V)  P
 Breakeven Analysis—Example
Q: Suppose a company can make a unit of product for $7 in variable
labor and materials, and sell it for $10. What are the contribution and
contribution margin?
Answer

The contribution per unit is $3, or $10 - $7,

while the contribution margin is $3  $10, or
30%.
 Breakeven Analysis
• Calculating the Breakeven Sales Level
– EBIT is revenue minus cost, or
• EBIT = PQ – VQ – FC
– Breakeven occurs when revenue (PQ) equals total
cost (VQ + FC), or
• QB/E = FC  (P – V)
– Breakeven tells us how many units have to be sold to
contribute enough money to pay for fixed costs
– Can also be expressed in terms of dollar sales
» SB/E = P(FC)  (P – V) or FC  CM
 Breakeven Analysis—Example
Q: What is the breakeven sales level in units and dollars for a company
that can make a unit of product for $7 in variable costs and sell it for
$10, if the firm has fixed costs of $1,800 per month?
Answer

The breakeven point in units is $1,800  ($10 -

$7) = 600 units. The breakeven point in dollars
is $10 per unit times 600 units, or $6,000, which
could also be calculated as $1,800  0.30. Thus,
the firm must sell 600 units per month to cover
fixed costs.
 The Effect of Operating Leverage
• As volume moves away from breakeven, profit or loss
increases faster with more operating leverage
• The Risk Effect
– More operating leverage leads to larger variations in EBIT,
or business risk
• The Effect on Expected EBIT
– Thus, when a firm is operating above breakeven, more
operating leverage implies higher operating profit
• If a firm is relatively sure of its operating level, it is in the firm’s
best interests to trade variable costs for fixed cost (assuming the
firm is operating above breakeven)
Figure 6: Breakeven Diagram at High and
Low Operating Leverage
 The Effect of Operating Leverage—
Example
Q:Suppose Firm A has fixed costs of $1,000 per period, sells
its product for $10, and has variable costs of $8 per unit.
Further, suppose Firm B has fixed costs of $1,500 and also
sells its product for $10 a unit. Both firms are at the same
breakeven point. What variable cost must Firm B have if it is
to achieve the same breakeven point as Firm A? State the
trade-off at the breakeven point. Which structure is
preferred if there’s a choice?
A: Both firms have a breakeven point of 500 units (Firm
A: $1,000  $2). We need to solve the breakeven
formula for Firm B’s variable costs per unit:

QB/EFirm B = FC  (P – VB) Thus, at breakeven, a $1

500 units = $1,500  ($10 – V B) differential in contribution

makes up for a $500
VB = $7 difference in fixed cost.

The preferred structure depends on volatility—if sales

are expected to be highly volatile, the lower fixed cost
structure might be better in the long run.
 The Degree of Operating Leverage
(DOL)—A Measurement
• Operating leverage amplifies changes in sales
volume into larger changes in EBIT
• DOL relates relative changes in volume (Q) to
relative changes in EBIT
%  EBIT Q(P - V)
DOL = or
%Q Q(P - V) - FC
 The Degree of Operating Leverage
(DOL)—A Measurement
Q: The Albergetti Corp. sells its product at an average price of $10. Variable costs are $7 per
unit and fixed costs are $600 per month. Evaluate the degree of operating leverage when
sales are 5% and then 50% above the breakeven level.

A: First, compute the breakeven volume: $600  ($10 - $7) = 200 units. Breakeven plus 5%
is 200 x 1.05 or 210 units, while breakeven plus 50% is 200 x 1.50 or 300 units. DOL at
210 units is:

210($10 - $7)
DO L Q=210 = = 21
210($10 - $7) - $600
DOL at 300 units is:
Note that DOL decreases
300($10 - $7) as the output level
DO L Q=300 = = 3
300($10 - $7) - $600 increases above
breakeven.
 Comparing Operating and Financial
Leverage
• Financial and operating leverage are similar in that both can
enhance results while increasing variation
• Financial leverage involves substituting debt for equity in the
firm’s capital structure
• Operating leverage involves substituting fixed costs for
variable costs in the firm’s cost structure
• Both methods involve substituting fixed cash outflows for
variable cash outflows
• Both kinds of leverage make their respective risks larger as the
levels of leverage increase
– However, financial risk is non-existent if debt is not present, while
business risk would still exist even if no operating leverage existed
• Financial leverage is more controllable than operating
leverage
 The Compounding Effect of
Operating and Financial Leverage
• The effects of financial and operating leverage
compound one another
• Changes in sales are amplified by operating leverage
into larger relative changes in EBIT
– Which in turn are amplified into still larger relative changes
in ROE and EPS by financial leverage
• The effect is multiplicative, not additive
– Thus, fairly modest changes in sales can lead to dramatic
changes in ROE and EPS
• The combined effect can be measured using degree
of total leverage (DTL)
– DTL = DOL × DFL
Figure 9: The Compounding Effect of Operating
Leverage and Financial Leverage
 The Compounding Effect of Operating
and Financial Leverage—Example

Q: The Allegheny Company is considering replacing a manual production process with a

machine. The money to buy the machine will be borrowed. The replacement of people
with a machine will alter the firm’s cost structure in favor of fixed costs, while the loan will
move the capital structure in the direction of more debt. The firm’s leverage positions at
expected output levels with and without the project are summarized as follows:

DOL DFL
Current 2.0 1.5
Proposed 3.5 2.5

The economic outlook is uncertain and some managers fear a decline in sales of as much as
10% in the coming year. Evaluate the effect of the proposed project on risk in financial
performance.
Answer

The firm’s current DTL is 2 x 1.5, or 3, meaning a

10% decline in sales could result in a 30%
decline in EPS. Under the proposal, the DTL will
be much higher: 8.75, or 3.5 x 2.5, meaning a
10% drop in sales could lead to a 87.5% drop in
EPS.
 Capital Structure Theory
• Does capital structure affect stock price and
the market value of the firm?
– If so, is there an optimal structure that maximizes
either or both?
• Results indicate that capital structure does
impact stock prices but there’s no way to
determine the optimal structure with any
precision
 Background—The Value of the Firm

• Notation
– Vd = market value of the firm’s debt
– Ve = market value of the firm’s stock or equity
– Vf = market value of the firm in total
• Vf = Vd + Ve
• Investors’ returns on the firm’s securities will be
– Kd = return on an investment in debt
– Ke = return on an investment in equity
• Theory begins by assuming a world without taxes or
transaction costs, so investors’ returns are exactly
component capital costs
– Ka = average cost of capital
 Background—The Value of the Firm

• Value is Based on Cash Flow Which Comes from

Income
– Earnings ultimately determine value because all cash flows
paid to investors come from earnings
– Dividends and interest payments are both perpetuities
• The firm’s market value is the sum of their present values

annual interest paid to bondholders total annual dividend paid to stockholders

Vf = +
kd ke
which is equivalent to saying
Operating Income
Vf =
ka
 Figure 10: Variation in Value and
Average Return with Capital Structure

The value of the firm

and the firm’s stock
price reach a
maximum when the
average cost of capital
is minimized.
 The Early Theory by Modigliani and
Miller (MM)
• Restrictive Assumptions in the Original
Model
– In 1958 MM published their first paper on
capital structure
• Included numerous restrictions such as
– No income taxes
– Securities trade in perfectly efficient capital markets
with no transaction costs
» No costs to bankruptcy
– Investors and companies can borrow as much as
they want at the same rate
 The Early Theory by Modigliani and
Miller (MM)
• The Assumptions and Reality
– Realistically income taxes exist
– Realistically the costs of bankruptcy are quite large
– Realistically individuals cannot borrow at the same
rate as companies and interest rates usually rise as
more money is borrowed
 The Early Theory by Modigliani and
Miller (MM)
• The Result
– Under MM’s initial set of restrictions, value is
independent of capital structure
– As cheaper debt is added the cost of equity
increases because of increased risk
• However the weight of the more expensive equity is
decreasing while the weight of the cheaper debt is
increasing, leading to a constant weighted average cost
of capital
Figure 11: The Independence
Hypothesis
 The Early Theory by Modigliani and
Miller (MM)
• The Arbitrage Concept
– Arbitrage means making a profit by buying and selling the
same thing at the same time in two different markets
– MM proposed that arbitrage by equity investors would
hold the value of the firm constant as debt levels changed
• Equity investors could sell shares in a leveraged firm and buy
shares in an unleveraged firm by borrowing money on their own

• Interpreting the Result

– The MM result implies that leverage affects value because
of market imperfections
• Such as taxes and transaction costs (including bankruptcy)
 Relaxing the Assumptions—More
Insights
• Financing and the Tax System
– Tax system favors debt financing over equity
financing
• Interest expense on debt is tax deductible while
dividends on stock are not
Table 4

The All Equity firm

pays more taxes
because it receives
no interest expense
deduction.

Total payments to
investors are higher
for the leveraged
company.
 Relaxing the Assumptions—More
Insights
• Including Corporate Taxes in the MM
Theory
– When taxes exist operating income (OI)
must be split between investors and the
government
• This lowers the firm’s value compared to what
it would be if no taxes existed
– Amount of reduction depends on the firm’s use of
leverage
» Use of debt reduces taxable income which
reduces taxes
 Including Corporate Taxes in the MM
Theory
• In the MM model with taxes interest provides a tax
shield that reduces government’s share of the firm’s
earnings
– When a firm uses debt financing the government’s take is
reduced by (corporate tax rate × interest expense) every
year
• Present value of tax shield = (corporate tax rate × interest
expense)  kd
• Since interest is the amount of debt (B) times the interest rate on
the debt, the above equation can be written as
corporate tax rate x B x k d
PV of tax shield = = TB
kd
 Including Corporate Taxes in the MM
Theory
• Having debt in the capital structure increases
a firm’s value by the magnitude of that debt
times the tax rate
• The benefit of debt accrues entirely to
stockholders because bond returns are fixed
Figure 12: MM Theory with Taxes

In the MM model with taxes

value increases steadily as
leverage is added. Thus, the
firm’s value is maximized with
100% debt. Note that kd
remains constant across all
levels of debt.
 Including Bankruptcy Costs in the
MM Theory
• As leverage increases past a certain point,
investors begin raising their required rates of
return
– The probability of bankruptcy failure increases
• Eventually the weighted average cost of
capital will be minimized and the firm value
will be maximized
– The MM model with taxes and bankruptcy costs
concludes that an optimal capital structure exists
Figure13: MM Theory with Taxes
and Bankruptcy Costs
Thank You!