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Welcome To The Presentation: Presenter: Dibakar Chandra Das

Dibakar Chandra Das presented on leverage and capital structure. Leverage refers to using assets or financing that requires fixed costs. There are two types of leverage: operating and financial. Operating leverage results from fixed operating costs, while financial leverage results from fixed financing costs. Capital structure refers to the mix of debt and equity used by a firm. There are various theories on the optimal capital structure that maximizes firm value, including the net income approach, traditional approach, and Modigliani-Miller approach with and without taxes. Signaling theory and pecking order theory also provide perspectives on capital structure decisions.

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50 views

Welcome To The Presentation: Presenter: Dibakar Chandra Das

Dibakar Chandra Das presented on leverage and capital structure. Leverage refers to using assets or financing that requires fixed costs. There are two types of leverage: operating and financial. Operating leverage results from fixed operating costs, while financial leverage results from fixed financing costs. Capital structure refers to the mix of debt and equity used by a firm. There are various theories on the optimal capital structure that maximizes firm value, including the net income approach, traditional approach, and Modigliani-Miller approach with and without taxes. Signaling theory and pecking order theory also provide perspectives on capital structure decisions.

Uploaded by

dibakardas10017
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 25

Welcome

to
the Presentation
Presenter:
Dibakar Chandra Das
Today’s Topic
Leverage & Capital Structure
Part-1
Leverage
Leverage
The employment of an asset or a sources of funds for which
the firm has to pay a fixed cost or fixed return may be
termed as leverage.

Fixed costs may be associated:

 either with its sales and production operations or


 with the types of financing it uses.
Types of leverage
There are two types of leverage:

a. Operating leverage
b. Financial leverage
a. Operating leverage
•Operating
  leverage results from the existence of fixed
operating costs. This may be defined as the firm’s ability to
use fixed operating costs to magnify the effects of changes in
sales on its EBIT.

Degree of operating leverage: It is a measure used to evaluate


how a company's operating income changes with respect
to a percentage change in its sales. The formula is:

DOL=

If proportionate change in EBIT is more than the proportionate change in sales,


operating leverage exists. The greater the DOL, the higher the operating leverage .
Operating leverage (continued..)

Business risk: Business risk is closely related with operating


leverage.

“Business risk is the inherent uncertainty in the firm’s regular


operations ignoring any financial effects. “

The larger the operating leverage, the larger the business risk. Higher operating
leverage is good when revenues are rising and bad when they are failing.
b. Financial leverage
•Financial
  leverage results from the presence of fixed financial
charges. It may be defined as the ability of a firm to use fixed
financial charges to magnify the effects of changes in EBIT on the
EPS.

Degree of operating leverage: It is a measure used to evaluate the


sensitivity of a company’s EPS with respect to a percentage change
in its EBIT, as a result of changes in its capital structure. The
formula is:

DFL=

If proportionate change in EPS is more than the proportionate change in EBIT,


financial leverage exists. The greater the DFL, the higher the financial leverage.
Financial leverage (continued….)
Financial risk: This risk arises from the using the financial
leverage.

“Financial risk refers to the risk of the firm not being able to
cover its fixed financial costs by a firm.”

Higher fixed financial costs increase the financial leverage and thus financial
risk.
Part-2
Capital Structure
Capital Structure
Simply capital structure is the composition of all sources of
capital of a firm. capital structure tells us how much
proportion of capital will be financed through either debt
or equity.

In other word, capital structure is the mix of a company's capital


in terms of equity, debt and hybrid securities.
Optimal Capital Structure
An optimal capital structure is the best debt-to-equity ratio
for a firm that maximizes its value.

“In general, the optimal capital structure is a mix of debt and


equity that seeks to lower the cost of capital and maximize the
value of the firm.”
Factors of Capital Structure Decision

Four major factors are:

a) Business Risk
b) Company's Tax position
c) Financial Flexibility
d) Managerial Attitude
Major Capital Structure Theories

a. Net Income Approach


b. Net Operating Income Approach
c. Traditional approach
d. Modigliani and miller approach
e. Signaling theory
f. Pecking order theory
Net Income Approach
This approach recognize the relevancy of capital structure
decision to the valuation of the firm.
According to NI approach,

“If the financial leverage increases, the weighted average cost of capital
decreases and the value of the firm and the market price of the equity
shares increases and vice versa.”

As the degree of leverage increases, the proportions of cheaper source of fund


increase. So WACC decline, leading to an increase in the total value of the
firm.
Assumptions of NI approach:
• No taxes
• Cost of debt is less than the cost of equity.
• Use of debt does not change the risk perception of the investors
Net Operating Income Approach
This approach is totally opposite to the NI approach. This
theory does not recognize the relevancy of capital structure
decision to the valuation of the firm.

According to this approach:


“There is nothing such an optimal capital structure. Any capital
structure is optimal according to this theory.”

Because when firm use debt, the risk associated with firm
also increase. So the equity holders demand more return and
ultimately the cost of equity increases. Finally the benefit of
inclusion of debt will be neutralized by the simultaneous
increase in the cost of equity.
Traditional approach
The traditional view is a compromise between the net income
approach and the net operating approach.

According to this view:

“The value of the firm will increase and WACC will decrease up to a
certain level of leverage. After that point, firm become financially
more risky and equity holder will demand more return on their
equity. So benefit of leverage will begin to decrease after this point
and WACC will begin to increase. Thus optimal capital structure
will be at that point where WACC is minimized and value of firm is
maximized”
Modigliani and Miller approach:
Without Taxes
Proposition 1: The WACC will remain constant with changes in
the company's capital structure. Because there will be no tax
benefit from interest payments. So the capital structure does not
influence a company's stock price, and the capital structure is
therefore irrelevant to a company's stock price.

Value of levered firm=Value of unlevered firm


Modigliani and Miller approach:
Without Taxes
(Continued….)
•Proposition
  2: Financial leverage is in direct proportion to
the cost of equity. With an increase in debt component, the
equity shareholders perceive a higher risk for the company.
Hence, in return, the shareholders expect a higher return,
thereby increasing the cost of equity.
=+ x ()
Where,
= cost of levered equity;
= Cost of unlevered equity
= Cost of debt
Here always
Modigliani and Miller approach:
With Taxes

Proposition 1: Corporation can increase the value of firm


through leverage because of the tax benefit of debt. Because
corporation can deduct interest payments but not dividend
payment.

But this proposition also states that a company can capitalize its
requirements with debts as long as the cost of distress i.e. the cost of
bankruptcy exceeds the value of tax benefits.

This proposition is also called the trade-off theory of leverage.


Modigliani and Miller approach:
With Taxes
(Continued….)
•Proposition
  2: Required return to equity holder rises with
leverage because risk to equity holder rises with leverage. But
MM argue that finally WACC will decline with leverage in
taxed world because tax shield.
=+ x ()x(1-)
Where,
= cost of levered equity;
= Cost of unlevered equity
= Cost of debt
= Tax rate
Here always
Signaling theory

Signaling theory states that the announcement of a stock


offering by a mature firm that seems to have multiple
financing alternatives is taken as a signal that firm’s future
prospects as seen by management are not good. Because if
firm’s future prospect is good, then usually firm will not
dilute its ownership by selling new stock.

So according to this theory, issuing debt is good because


firm is confident enough to pay debt interest.
Pecking order theory
Use internal financing: Firm normally issue equity when
future growths are not good or the equity is overvalued.
Sometimes investors might see the existing debt of a firm is
nearly risk free, when manager see trouble ahead. So
rational investors may view that debt or equity is issued
when the firm is overvalued. So price may fall.

Here pecking order theory suggests that:

“Firm should use internal source i.e. retained earnings as far it


can avoid going to investors in the first place.”
Pecking order theory
(Continued….)

Issue safe securities first: Issuing equity has a signaling


effect on stock. Though investors fear mispricing of both
debt and equity but the fear is much greater for equity.
Because debt has relatively little risk because if financial
distress is avoided, investors receive fixed return.

So pecking order theory suggest that:

“if outside financing is required, debt should be issued before


equity unto the firm’s optimal debt capacity. Then equity comes.”
Thank you

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