Unit III

Financing Decisions
Leverage Analysis
Introduction:
• The financing decision of a company affects shareholder return and risk.
• Capital structure includes both debt and equity.
• Debt involves fixed interest payments, while equity represents owner's capital. Using more debt can increase
both risk and return to equity shareholders.
Leverage:
• Leverage is the firm's ability to use long-term funds with fixed costs to enhance returns to owners.
• In leverage analysis, we discuss the impact of fixed operating and financial costs on earnings available to
equity shareholders.

Business and Financial Risks

Business Risk:
• This refers to the variability in a firm's expected earnings before interest and taxes (EBIT), caused by factors
inherent in the business environment, such as fire, labour unrest, business recession, technological changes,
competition, government policies, fashion changes, and natural calamities.
• It's also known as operating risk.
Financial Risk:
• This arises from the firm's financing decisions, specifically the use of financial leverage (debt and preference
share capital).
• Financial risk affects the variability in earnings for equity shareholders and the potential for insolvency.
Difference between Business Risk and Financial Risk

Types of Leverage
• Operating Leverage
• Financial Leverage
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 • Combined Leverage

Operating Leverage
• Operating leverage is the leverage associated with operating risk. It is high in firms with a high proportion
of fixed costs in their cost structure, and it measures the effect of changes in sales revenue on EBIT.
• Leverage related to the operations of the business due to fixed costs.
• Operating leverage is the firm’s ability to use fixed operating costs to magnify the effect of changes in sales
on its EBIT.
• Operating leverage is the relationship between the firm’s sales revenue and its earnings before interest and
tax (EBIT).
• When the percentage change in EBIT is more than the percentage change in sales, the operating leverage is
said to exist and its measure is called degree of operating leverage.

• Factors Influencing Operating Leverage:

o Amount of Fixed Costs: Higher fixed costs lead to higher operating leverage.
o Level of Sales Achieved: Sales above the break-even point result in positive leverage.
o Proportion of Variable Costs to Sales (Contribution): Determines the margin.

Financial Leverage
• Financial leverage results from the existence of fixed financial charges in the firm's income stream.
• These charges do not change with changes in EBIT (Earnings Before Interest and Taxes).
Impact:
• Financial leverage can increase EPS (Earnings Per Share) because debt is considered a cheaper source of
finance due to tax deductibility.
• However, if earnings are not enough to cover fixed financial charges, EPS will decline.
Key Concepts:
• Trading on Equity: Use of fixed financial charges to magnify the effects of changes in EBIT on EPS.
• Fixed Charges: Include interest on debts and preference dividends.
• Formula:

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• The degree of financial leverage is the measure of financial leverage and can also be calculated as follows:

• Importance of Financial Leverage:

• Helps financial managers decide on borrowing.
• Favourable if ROI > cost of debt, leading to higher earnings for equity shareholders.
• Unfavourable financial leverage means borrowing shouldn't be done.

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Combined Leverage
• Measures total risk
• The combined leverage or total leverage arises from fixed operating costs and fixed interest expenses.
• The combined leverage arises from fixed operating costs and fixed interest expenses.
• Combined leverage shows the effect of both operating and financial leverage on the EPS

Three Situations of Firms Based on Leverages:

1. Risky Situation: Both operating and financial leverage are high.
2. Normal Situation: One leverage is high, and the other is low.
3. Ideal Situation: Both leverages are low.
Importance of Leverage Analysis:
• Investment Decisions:
o Helps in deciding on investments by measuring a firm's ability to use fixed operating costs to impact
EBIT.
o Favourable leverage increases earnings available to shareholders if the expected contribution exceeds
the increase in fixed costs.
• Financial Decisions:
o Useful for evaluating financing alternatives and determining the optimal capital structure.
o Financial leverage measures the ability to use fixed financial charges to magnify EBIT's effects on
EPS.
▪ Favourable if ROI > cost of debt.
• Measuring Risks:
o Operating leverage indicates business risk (changes in EBIT due to fixed operating costs).
o Financial leverage indicates financial risk (ability to maximize shareholder earnings through debt).
• Maximizing Shareholder Wealth:
o Helps in finding a financing mix and capital structure that maximizes earnings for equity
shareholders.
Limitations of Leverage Analysis:

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• Explicit Cost of Debt:
o Only considers given costs of debt, ignoring the implicit cost (increased equity cost).
o More financial leverage increases shareholder expectations and equity cost, potentially reducing
market share value.
• Constant Cost of Capital:
o Assumes a constant cost of capital, which is not true in practice.

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Capital Structure
Introduction:
• Capital structure refers to the use of long-term funds by a firm, including debt and equity capital.
• Capital structure decision in important in maximizing shareholder wealth by balancing debt and equity.
Key Concepts:
• Debt vs. Equity: The mix of debt and equity impacts financial risk and earnings per share.
• Financial Decisions: The firm’s earnings are used to pay interest on debt, taxes, and then distributed to
shareholders.
Assumptions of Capital Structure Theories:
• Firm employs only debt and equity.
• No corporate taxes.
• No expected growth to operating profit
• Constant total assets and no growth in operating profits.
• Dividend-payout ratio is 100%.
• Constant business risk.
• Investors have the same expectations for future earnings.
• Total financing remains constant.

Factors Affecting Capital Structure

1. Risk:
o Business Risk: Changes in demand, price, competition, and costs. Firms with high business risk
borrow less due to unstable earnings.
o Financial Risk: Associated with financial leverage and fixed cost-bearing funds like debentures.
Higher debt increases financial risk and fixed commitments. Equity financing avoids fixed
commitments like interest.
2. Control:
o Debt should be used to a level where shareholder control isn't diluted.
o Equity shareholders have decision-making power. Issuing debt doesn't dilute control as equity does.
o Preferences for debt or equity depend on control considerations and EPS goals.
3. Profitability:
o Capital structure should maximize profits.
o Higher debt financing can increase returns if the return on assets exceeds the cost of debt.
4. Cost of Capital
o Must generate enough earnings to meet capital costs.
o High business and financial risk increase the cost of funds.
o Excessive debt raises equity shareholders' risk perception.

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5. Trading on Equity
o Debentures and preference shares offer fixed returns.
o Beneficial if ROI exceeds debt costs.
o Stable earnings needed to manage fixed financial obligations.
6. Flexibility
o Capital structure should adapt to changing conditions.
o Debt can be easily raised or repaid.
o Equity capital can be reduced through buy-backs.
7. Attitude of Investors
o Different securities cater to risk-tolerant and risk-averse investors.
o Equity suits risk-takers; debentures for cautious investors.
8. Nature of Business
o Stable earnings can support fixed interest and dividends.
o Companies with irregular earnings should rely on equity capital.
9. Size of the Company
o Large companies can leverage borrowing and public equity issues.
o Small companies often depend on owner's funds.
10. Purpose of Financing:
o Long-term funds: Used for long-term projects.
o Short-term funds: Used for short-term projects; debentures, bank loans.
o Productive purposes: Generate revenue; e.g., buying a plant.
o Unproductive activities: Prefer internally generated funds or equity shares.
11. Timing of Issue:
o Economic state: Boom or recession impacts when to issue securities.
o Government policies: Monetary and fiscal policies influence funding cost.
o Interest rates: Evaluate market conditions and future cost of funds.
12. Tax Planning:
o Interest on debt: Deductible, reducing tax liability.
o Dividends: Not tax-deductible; company pays corporate dividend tax.
o Floatation costs: Deductible over 10 years; capitalize if pre-commencement.
13. Debt-Equity Ratio:
o Industry standards: Compare with similar companies to assess risk conservativeness or
aggressiveness.
14. Consulting Lenders and Bankers:
o Expert advice: Investment bankers and lenders provide valuable insights on market securities.

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Theories of Capital Structure:
1. Net Income Approach: Suggests that changes in capital structure can impact the firm's value.
2. Net Operating Income Approach: Claims that the firm's value is unaffected by capital structure.
3. Modigliani-Miller Approach: Proposes that, under certain conditions, capital structure is irrelevant to firm
value.
4. Traditional Approach: Believes there is an optimal capital structure that balances debt and equity to
maximize firm value.

Net Income Approach

Overview:
• Proposed by David Durand.
• Suggests a relationship between capital structure and firm value.
• Changes in capital structure affect the overall cost of capital and firm value.
• Assumptions:
1. No corporate taxes.
2. Cost of debt is less than cost of equity.
3. Debt content doesn't change investor risk perception.
Implications:
• Increasing debt proportion reduces the weighted average cost of capital due to cheaper debt.
• Increasing debt raises shareholder earnings and market value, increasing firm value.
• Reducing debt increases overall cost of capital, decreasing firm value.
• Financial leverage is a crucial variable in capital structure.
Key Conclusions:
• Value of the Firm: Increased use of debt raises firm value, assuming the cost of equity and debt remain
constant.
• Cost of Equity: Remains unaffected by debt proportion changes.
• Overall cost of capital: With increased debt proportion or financial leverage, the overall cost of capital (k₀)
declines.
• Optimum capital structure: A firm will have its optimum capital structure when it has 100% debt contents
(theoretical). A combination of debt and equity minimizes k₀ and maximizes the firm's value.

Net Operating Income Approach

• Capital structure decision is independent and doesn't influence the firm's value or overall cost of capital.
• Market value of the firm is calculated by capitalizing the net operating income at the overall cost of capital,
which is constant.
• The earning potential is constant, unaffected by changes in the source of finance.
Assumptions of NOI approach:
1. Net operating income remains constant.
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 2. Investors use the same discount rate.
3. The cost of debt (Kd) remains constant.
4. Increased debt results in increased risk for shareholders.
5. No taxes.
Conclusions of NOI Approach:
• Value of the Firm: Independent of capital structure; dependent on asset investments and business risk.
• Overall Cost of Capital: Unaffected by debt-equity mix; increase in debt raises the cost of equity due to
increased shareholder risk.
• Overall Cost of Capital (k₀): Remains constant across different levels of debt-equity mix. With increased
debt (a cheaper finance source), the risk for equity shareholders rises, increasing the cost of equity (kₑ).
• Cost of Equity (kₑ): Increases with higher debt content in the capital structure due to increased financial
risk. Changes linearly with the proportion of debt.
• Optimum Capital Structure: According to the NOI approach, there's no specific optimum capital structure.
All capital structures could be considered optimal as the overall cost of capital remains constant.

Traditional Approach
• Contrasts with NI and NOI approaches:
o NI Approach: Debt affects overall cost of capital and firm value.
o NOI Approach: Debt does not affect overall cost of capital and firm value.
• Traditional Approach: Indicates an optimal capital structure can minimize the cost of capital and maximize
firm value. With increased debt, the firm's value initially rises due to the tax deductibility of debt. However,
beyond a certain debt level, increased financial risk raises the cost of equity, leading to a higher overall cost
of capital and reduced firm value. The optimal capital structure minimizes the overall cost of capital.

Conclusion of the Traditional Approach

• Value of the Firm: Initially rises with increased debt due to tax
deductibility. Beyond a certain debt level, increased financial
risk raises the cost of equity, leading to higher overall costs and
reduced firm value.
• Cost of Equity: Although it rises with increased debt, the initial advantage of cheaper debt can outweigh
this rise until a certain point.

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• Overall Cost of Capital: Decreases initially with more debt, as debt is cheaper than equity. After a certain
level, the cost of equity and further debt rises, increasing the overall cost.
• Optimum Capital Structure: According to the traditional approach, there exists an optimum capital
structure.

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