Title: The Concepts of Leverage and capital Structure Theories

A Term Paper for Advanced Financial Management

School of Post graduate Studies

Admas University

Submitted by: Section 2 Group 3 students

Submitted to: Gidey G. (Ph.D)

Group Members ID No
1. MulugetaChekol-----------------------PGMGB/1417/22
2. MuluemebetAklilu-------------------PGMGB/1100/22
3. FevenZewdie------------------------PGMGB/1160/22
4. MamitDerbie-------------------------PGMGB/1137/22
5. AbebeHabtamu----------------------PGMGB/1355/22
6. AbebayehuYifru---------------------PGMGB/1048/22
7. RedietTegegn------------------------PGMGB/1389/22
8. Firew Takele-----------------------PGMGB/1371/22
9. RomanTayine------------------------PGMGB/1110/22

July, 2023
Contents

Introduction......................................................................................................................................................1
Literature Review.............................................................................................................................................2
Advantages of the Leverage.............................................................................................................................6
Disadvantages of Leverage..............................................................................................................................6
Advantages of Right Capital Structure............................................................................................................7
Disadvantages of not having right capital structure.........................................................................................7
References........................................................................................................................................................9
 Introduction

Leverage is the use of debt or borrowed capital in order to undertake an investment or project. It is
commonly used as a way to boost an organizations equity base. The concept of leverage is used by
both investors and companies. Investors use leverage to significantly increase the returns that can
be provided on an investment. They leverage their investments by using various instruments.
Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise
capital, companies can use debt financing to invest in business operations in an attempt to increase
shareholder value.

Leverage is an investment strategy of using borrowed money—specifically, the use of various

financial instruments or borrowed capital—to increase the potential return of an investment.
Leverage can also refer to the amount of debt a firm uses to finance assets. Financial leverage is
achieved by borrowing money to invest in an asset or business. The goal is to increase the return on
investment (ROI) by using borrowed funds to generate a higher return than the cost of the debt.

A company can analyze its leverage by seeing what percent of its assets have been purchased using
debt. If the debt-to-assets ratio of a certain company is high, a company has relied on leverage to
finance its assets. A D/E ratio greater than one means a company has more debt than equity.
However, this doesn't necessarily mean a company is highly leveraged. Each company and industry
typically operates in a specific way that may warrant a higher or lower ratio.

Capital structure is the particular combination of debt and equity used by a company to finance its
overall operations and growth. Equity capital arises from ownership shares in a company and
claims to its future cash flows and profits. Debt comes in the form of bond issues or loans, while
equity may come in the form of common stock, preferred stock, or retained earnings. Short-term
debt is also considered to be part of the capital structure.

Both debt and equity can be found on the balance sheet. Company assets, also listed on the
balance sheet, are purchased with debt or equity. Capital structure can be a mixture of a company's
long-term debt, short-term debt, common stock, and preferred stock. A company's proportion of

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 short-term debt versus long-term debt is considered when analyzing its capital structure. Debt is
one of the two main ways a company can raise money in the capital markets. Companies benefit
from debt because of its tax advantages; interest payments made as a result of borrowing funds
may be tax-deductible. Debt also allows a company or business to retain ownership, unlike equity.
Additionally, in times of low-interest rates, debt is abundant and easy to access. Equity allows
outside investors to take partial ownership of the company. Equity is more expensive than debt,
especially when interest rates are low. However, unlike debt, equity does not need to be paid back.
This is a benefit to the company in the case of declining earnings. On the other hand, equity
represents a claim by the owner on the future earnings of the company.

Companies that use more debt than equity to finance their assets and fund operating activities
have a high leverage ratio and an aggressive capital structure. A company that pays for assets with
more equity than debt has a low leverage ratio and a conservative capital structure. That said, a
high leverage ratio and an aggressive capital structure can also lead to higher growth rates,
whereas a conservative capital structure can lead to lower growth rates.

Literature Review

One important factor in the funding element is debt (leverage). This means how much debt is borne
by the company compared to its assets. Solvency (leverage) is described to see the extent to which
the company's assets are financed by debt compared to equity (Sari and Handayani, 2016).
Leverage provides an overview of the capital structure of the company, so that it can be seen the
risk of uncollectible debt (Sari and Priyadi, 2016)

Companies with low leverage ratios have a smaller risk of leverage (Astriani, 2014). In this study
the leverage ratio that becomes the independent variable is DER. Debt to equity ratio (DER) is a
comparison between the amounts of long-term debt with own capital or equity in corporate
funding. This ratio shows the company's ability to fulfill all its obligations with its own capital. The
higher the value of this ratio means that there is less own capital compared to the debt (Sambora, et
al., 2014).

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Capital structure irrelevance theory of Modigliani considers that firm value is unaffected by the
capital structure of the firm. Securities are traded in perfect capital market, all relevant information
are available for insiders and outsiders to take the decision (no asymmetry of information), that is
transaction cost; bankruptcy cost and taxation do not exist (Modigliani and Miller, 1958).

Borrowing and lending is possible for firms and individual investors at the same interest rate
which permits for homemade leverage, firms operating in a similar risk classes and have similar
operating leverage, interest payable on debt do not save any taxes and firms follow 100% dividend
payout. Under these assumptions MM theory proved that there is no optimal debt to equity ratio
and capital structure is irrelevant for the shareholders wealth. This preposition presented by
Modigliani and Miller seminar paper argues that value of levered firm is same as the value of
unlevered firm. Therefore they propose that managers should not concern the capital structure and
they can freely select the composition of debt to equity (Modigliani and Miller 1958).

Capital structure irrelevance theory was theoretically very sound but was based on unrealistic set of
assumptions. Therefore this theory led to a plenty of research on capital structure. Even though
Modigliani and Miller theory was valid theoretically, world without taxes were not valid in reality.
In order to make it more accurate incorporated the effect of tax on cost of capital and firm value. In
the presence of corporate taxes, the firm value increase with the leverage due to the tax shield.
Interest on debt capital is an acceptable deduction from the firm’s income and thus decreases the
net tax payment of the firm. This would result in an added benefit of using debt
capital through lowering the capital cost of the firm. Drawbacks in MM theory stimulated series of
research devoted on proving irrelevance as theoretical and empirical matter. One of the basic
theory that have dominated the capital structure theory which recommends that optimal level of the
debt is where the marginal benefit of debt finance is equal to its marginal cost. Firm can achieve an
optimal capital structure through adjusting the debt and equity level thereby balancing the tax
shield and financial distress cost. There is no consensus among researchers on what consist of the
benefit and costs (Modigliani and Miller, 1963).

As debt capital increase WACC(weighted average cost of capital) of the firm declines until the

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firm reaches the optimal gearing level and cost of financial distress increases along with the debt
level (Arnold, 2008). This is confirmed by that the optimal debt to equity ratio shows the highest
possible tax shield that the company can enjoy (Miller, 1988). Firms increase the risk of
bankruptcy due to the debt capital in their capital structure. In the trade off theory cost of debt are
linked with direct as well as indirect cost of bankruptcy (Modigliani and Miller (1963), Miller
(1988). explained that Cost of bankruptcy include legal and administrative cost, other indirect cost
resulting from loosing of customers and trust between staff and suppliers due to the uncertainties
(Bradley et. al., 1984).

Debt can reduce the agency cost and argue that higher the debt capital grater the commitment to
pay out more cash. Though, Frank and Goyal (2008) contend that it is not been totally explained
the impact of agency conflicts on capital structure. Debt capital in the capital structure produce
valuable information in monitoring the agency behavior and for self-interest reasons managers are
reluctant to liquidate the firm or provide such information which could lead to bankruptcy. Debt
holders also concerned only on their benefit and would prefer firms to undertake safe investments
nut do not bother about the profitability of those investments (Harris and Raviv, 1990). This further
explains (Fama and French, 2002) that Due to the cost of debt agency conflicts arise between
shareholders and bondholders states that the presence of optimal capital structure or target capital
structure increases the shareholder wealth. Further this study explains that even the value
maximizing firm use debt capital to full capacity they face low probability of going bankrupt
(Fama and French, 2002).)

High profitability of gearing proposes that the firms’ tax shield higher and lower the possibility of
bankruptcy (Hovakimian et. al., 2004). This is consistent with the key prediction of the trade-off
model that there is a positive correlation between profitability and gearing. But none of these
theoretical and empirical studies fully substitute the traditional version and therefore researchers
still test the trade-off theory based on the original assumptions. In the literature contradictory
evidence can be found in favor and against the trade-off model and optimal capital structure.

Non-debt tax shield and use of debt capital in the capital structure is positively correlated.
Contradictory to this results (Titman and Wessels, 1988). Firms which incur a tax loss are rarely

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issue debt capital Modigliani and Miller, 1963) (Mackie-Mason, 1990). Gearing level of the firms
are steady even the tax rates vary to great extent (Wright, 2004). Optimal capital structure choice of
the firm would be to issue debt capital and/or equity capital.

Trade off theory postulate that all firms have an optimal debt ratio at which the tax shield equal the
financial distress cost. This theory eliminates the impact of information asymmetry and
incorporating the different information on conflicts between insiders and outsiders Pecking Order
Theory proposed. Capital structure choice depend on tax rates (Aham and Harvey ,2001).

Assuming perfect capital market pecking order theory following the findings of Donaldson (1961)
which found that management prefer internally generated funds rather using external funds (Myers
and Majluf , 1984). Pecking order theory suggest that firm prefer internal financing over debt
capital and explains that firms utilize internal funds first then issue debt and finally as the last resort
issue equity capital. Firms prefer to finance new investments with internally generated funds first
and then with debt capital and as the last resort they would go for equity issue (Al-Tally, 2014).
Pecking order theory further explains that firms borrow more when internally generated funds are
not sufficient to fulfill the investment needs (Shyam-Sunder and Myers, 1999). Debt ratio of the
firm reflect the cumulative figure for external financing and firms with higher profit and growth
opportunities would use less debt capital (Myers, 2001). If the firm has no investment opportunities
profits are retained to avoid the future external financing. Further firms’ debt ratio represents the
accumulated external financing as the firm do not have optimal debt ratio.

Market timing theory of capital structure explains that firms issue new equity when their share
price is overrated and they buy back shares when the price of shares are underrated (Baker and
Wurgler, 2002).

Trade off theory assumes that firms have one optimal debt ratio and firm trade off the
benefit and cost of debt and equity financing. Pecking order theory assumes that firms follow a
financing hierarchy whereby minimize the problem of information asymmetry. But neither of these
two theories provides a complete description why some firms prefer debt and others prefer equity
finance under different circumstances (Myers, 1984, Myers and Majluf, 1984).

Another theory of capital structure has introduced recently that is market timing theory, which
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explains the current capital structure as the cumulative outcome of past attempts to time the equity
market (Baker and Wurgler, 2002). Market timing issuing behavior has been well established
empirically by others already, but show that the influence of market timing on capital structure is
regular and continuous (Baker and Wurgler, 2002).

Capital structure or financial leverage decision should be examined concerning how debt and
equity mix in the firm’s capital structure influence its market value. Debt to equity mix of the firm
can have important implications for the value of the firm and cost of capital. In maximizing
shareholders wealth firm use more debt capital in the capital structure as the interest paid is a tax
deductible and lowers the debt’s effective cost. Further equity holders do not have to share their
profit with debt holders as the debt holders get a fixed return. However, the higher the debt capital,
riskier the firm, hence the higher its cost of capital. Therefore it is important to identify the
important elements of capital structure, precise measure of these elements and the best capital
structure for a particular firm at a particular time (Yapa Abeywardhana, D. (2017.

Researchers and practitioners explain conflicting theories on capital structure. Using the Net
Income (NI) approach that firm can decrease its cost capital and consequently increase the value of
the firm through debt financing (Durand, 1952). Capital structure irrelevance that firm’s value is
independent of its debt to equity ratio which is known as Net Operating Income (NOI) approach
(Modigliani and Miller, 1958). They argue that perfect capital market without taxes and transaction
cost the firm value remains constant to the changes in the capital structure. According to the
traditional approach of has emerged a compromise to the extreme position taken by the NI
approach (Solaman,1963)

Advantages of the Leverage

1. Powerful access to capital-Financial leverage multiplies the power of every dollar you put to
work. If used successfully, leveraged finance can accomplish much more than you could
possibly achieve without the injection of leverage. Investors and traders primarily use leverage
to amplify profits. Winners can become exponentially more rewarding when your initial
investment is multiplied by additional upfront capital. Using leverage also allows you to
access more expensive investment options that you wouldn't otherwise have access to with a

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 small amount of upfront capital.
2. Ideal for acquisitions, buyouts-Because of the additional cost and risks of bulking up on debt,
leveraged finance is best suited for brief periods where your business has a specific growth
objective, such as conducting an acquisition, management buyout, share buyback or a one-
time dividend. Leverage can be used in short-term, low-risk situations where high degrees of
capital are needed. For example, during acquisitions or buyouts, a growth company may have
a short-term need for capital that will result in a strong mid-to-long-term growth opportunity.
As opposed to using additional capital to gamble on risky endeavors, leverage enables smart
companies to execute opportunities at ideal moments with the intention of exiting their
leveraged position quickly.

Disadvantages of Leverage

1. Risky form of finance- Debt is a source of funding that can help a business grow more
quickly. Leveraged finance is even more powerful, but the higher-than-normal debt level can
put a business into a state of leverage that is too high which magnifies exposure to risk. If
winning investments are amplified, so are losing investments. Using leverage can result in
much higher downside risk, sometimes resulting in losses greater than your initial capital
investment. On top of that, brokers and contract traders often charge fees, premiums, and
margin rates. This means that if you lose on your trade, you'll still be on the hook for extra
charges.
2. More costly- Leveraged finance products, such as leveraged loans and high yield bonds, pay
higher interest rates to compensate investors for taking on more risk.

3. Complex-The financial instruments involved, such as subordinated mezzanine debt, are more
complex. This complexity calls for additional management time and involves various risks.
Leverage also has the potential downside of being complex. Investors must be aware of their
financial position and the risks they inherit when entering into a leveraged position. This may
require additional attention to one's portfolio and contribution of additional capital should their
trading account not have a sufficient amount of equity per their broker's requirement.

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 Advantages of Right Capital Structure

1. Every business has different needs, especially when it comes to capital structure. The cash
flow and financial support requirements for an international conglomerate are likely going to
be more involved and complicated than that of a mom n’ pop shop. Similarly, the
capitalization needs of a company focused on consumer goods, which may carry a lower risk,
will vary in comparison to a travel company, where needs and demands ebb and flow with the
seasons. But both businesses still need to determine what kind of capital structure is going to
help them be successful and meet their goals.
2. Risk analysis and debt management will also operate differently for business entities versus
individual proprietors, which is a key component to determining capital structure development
and management. By starting out with a strong foundation that limits liabilities, maximizes
cash flow, and keeps an eye on the proportion of debt and retained earnings, businesses can
create an optimal capital structure that will support their efforts—and encourage others’
support—for years to come.

Disadvantages of not having right capital structure

1. Not maintaining the right combination of capital structure may face organizations with risk
of not able to pay debt.

2. If there is no the right combination of capital structure organization’s cost of capital may
increase.

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