CAPITAL STRUCTURE

POLICY AND LEVERAGE

CHAPTER :1
 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
 Explain the essence of the capital structure question.

 Know factors influence capital structure decisions.

 Distinguish between business risk and financial risk.

 Explain business risk and operating leverage as well

as financial risk and financial leverage.

 Describe how to determine optimal capital structure.

 Explain different theories of capital structure like

Modigliani and Miller(M&M),Trade-off theory, Signaling

theory….
 Describe the use of debt financing to constrain
managers.
 1.1 The Capital Structure
Question
 Capital Structure is the combination of debt and
equity used to finance a firm’s projects.
 The capital structure of a firm is some mix of debt,
internally generated equity and new equity.
 The mix of debt, preferred stock, and common equity
with which the firm plans to raise capital.
 Is one better than the other? If so, should
firms be financed either with all debt or all
equity? If the best solution is some mix of debt
and equity, what is the optimal(right) mixture?
Cont…d

 The best capital structure depends on several

factors. If a firm finances its activities with
debt, the creditors expect the amount of the
interest and principal—fixed, legal
commitments—to be paid back as promised.
Failure to pay may result in legal actions by the
creditors.
Cont…d
1.2 Factors Influence Capital Structure
Decisions
 Capital structure policy involves a trade-off between risk
and return:
 Using more debt raises the risk borne by stockholders.
 However, using more debt generally leads to a higher
expected rate of return on equity.
 Higher risk tends to lower a stock’s price, but a higher
expected rate of return raises it.
 Therefore, the optimal capital structure must strike a
balance between risk and return so as to maximize the
firm’s stock price.
Cont….d

 Four primary factors influence capital structure decisions.

1. Business risk, or the riskiness inherent in the firm’s

operations if it used no debt. The greater the firm’s business
risk, the lower its optimal debt ratio.

2. The firm’s tax position. A major reason for using debt is

that interest is tax deductible, which lowers the effective
cost of debt.
 Cont…d

3. Financial flexibility, or the ability to raise capital on

reasonable terms under adverse conditions. Corporate treasurers
know that a steady supply of capital is necessary for stable
operations, which is vital for long-run success. They also know
that when money is tight in the economy, or when a firm is
experiencing operating difficulties, suppliers of capital prefer to
provide funds to companies with strong balance sheets.
Cont…d

4. Managerial conservatism or
aggressiveness.

Some managers are more aggressive than others,

hence some firms are more inclined to use debt
in an effort to boost profits. This factor does not
affect the true optimal, or value-maximizing,
capital structure, but it does influence the
manager determined target capital structure.
1.3 Business and Financial Risk
(1) business risk
 the riskiness of the firm’s stock if it uses no debt.
 Refers to the risk to the firm of being unable to
cover its operating costs.
 It refers to the relative dispersion(variability)in
the firm’s expected EBIT induced by the firm’s
investment decisions or it is the results of
investment decisions.
Financial risk-
 is the additional risk placed on the common
stockholders as a result of the firm’s decision to use
debt.
 is the risk to the firm of being unable to cover required

financial obligations.
 The more fixed-cost financing a firm has in its capital

structure, the greater its financial leverage and risk.

 Financial risk depends on the capital structure decision

made by the management.

1.3.1 Business Risk and Operating leverage

 Business risk depends on a number of factors:

1. Demand variability. The more stable the demand for a
firm’s products, other things held constant, the lower its
business risk.
2. Sales price variability. Firms whose products are sold in
highly volatile markets are exposed to more business risk than
similar firms whose output prices are more stable.
3. Input cost variability. Firms whose input costs are highly
uncertain are exposed to a high degree of business risk.
4. Ability to adjust output prices for changes
in input costs. Some firms are better able than
others to raise their own output prices when input
costs rise. The greater the ability to adjust output
prices to reflect cost conditions, the lower the
degree of business risk.
5. Ability to develop new products in a timely,
cost-effective manner.
Firms in such high-tech industries as drugs and
computers depend on a constant stream of new
products. The faster its products become obsolete,
the greater a firm’s business risk.
6. Foreign risk exposure. Firms that generate a high
percentage of their earnings overseas are subject to earnings
declines due to exchange rate fluctuations. Also, if a firm operates
in a politically unstable area, it may be subject to political risks.

7. The extent to which costs are fixed: operating leverage.

If a high percentage of costs are fixed, hence do not decline

when demand falls, then the firm is exposed to a relatively high
degree of business risk. This factor is called operating leverage.
LEVERAGE-

 refers to the effect that fixed costs have on the returns

that shareholders earn or in the process of magnifying
earnings.
 Leverage magnifies the impact of a change
in sales into a higher change in EBIT or a
change in EBIT into higher EPS.
 Therefore, leverage magnifies both risks and returns.
 When sales rise within a certain sales
range, fixed costs remain constant, leaving
more of the sales birr as operating profit.
 When operating profit goes up, creditors
will be paid the same fixed amounts for the
financing they provided, leaving more
money for the stockholders.
 Thus, leverage is a two-edged sword- it

cuts on both sides. In good times, it

magnifies returns and in bad times it
magnifies loses too.
 There are three types of leverage in

finance
1.Operating Leverage: shows the relationship between firms sales revenue and
earnings before interest tax (EBIT) of the firm.
 This measures the business risks.
Business risk refers to the variability to earnings before interest and taxes due
to improper products mix, non-availability of raw material, lack of strategic
management etc.
2. Financial leverage: shows the relationship between the firm’s EBIT and its
common stock’s earnings per share (EPS).
This measures the financial risks.
3. Total Leverage( combined leverage): is the sum of both operating and financial
leverage.
 It concerns on the firm’s sales revenue and EPS.
 This measures total leverage = total risks of the firm.
Leverage and Profit/loss statement
Sales
- Fixed costs operating Leverage
- Variable costs
EBIT Total
leverage
- Interest Financial leverage
EBT
- Taxes
EAT
 EPS
Note: EPS = EAT divided by number of shares outstanding
[assuming no preferred stock].
Leverage Analysis;
An Example of ABC Incorporated Profit/loss
Statement (Year ended December 31, 2022)

.
.
Note: The symbols………
P = price per unit
Q = sales in units
VC = variable cost per unit
FC = fixed costs
TVC = total variable costs
TC = FC + TVC = total costs
S = P*Q = Sales dollar or Birr
EBIT = S - TC
 Degree of Leverage

Determine the ABC‘S DOL When Q = 30,000
Units

30,000($25  $7)
DOL   2 .0
30,000($25  $7)  $270,000

For every 1% change in sales, EBIT will change 2%.

Operating Leverage is Risky:
The higher the degree of change, the higher the
risk.
 If sales increase by 5%, a DOL of 2.0 indicates
that EBIT would increase 10%.
 If sales decline by 7%, a DOL of 2.0 indicates that
EBIT would decline 14%.
B. Degree of Financial Leverage (DFL)


Illustration: what is ABC ’s DFL When Q =
30,000 Units
 DFL= EBIT = 270,000 = 2.7
EBIT-I 270,000-170,000

 For every 1% change in EBIT, EPS will change 2.7%  this shows
it is more risky.
Analysis of Financial Leverage
 If EBIT increases 2%, a DFL of 2.7 indicates that EPS would increase
5.4%.
 If EBIT declines 4%, a DFL of 2.7 indicates that EPS would decline
10.8%.
C. Combined Leverage

Degree of Combined Leverage

25

%  in EPS
DCL 
%  in Sales
Q( P  V )
=
Q( P  V )  F  I
S  VC S  VC
= 
S  VC  F  I EBT
 %  in EBIT   %  in EPS 
=  
 %  in Sales   %  in EBIT 
= (DOL)(DFL)
03/13/2025
Note: If F = 0, and I = 0, DCL = 1.0 (i.e.,
without F or I the % change in EPS would
be equal to the % change in sales). By
employing F or I (or both), the firm’s %
change in EPS will be greater than the %
change in sales.
ABC’s DCL When Q = 30,000 Units

27

30,000(25  7)
DCL 
30,000(25  7)  270,000  170,000
= (DOL)(DFL)
= (2)(2.7)
= 5.4

03/13/2025
1.4 Determining the optimal capital structure

 Value of the firm is maximized when the WACC is

minimized.
 Thus, the optimal capital structure is that at which the
WACC is minimized.
 The lower the firm’s WACC, the greater the difference
between the return on a project and this cost and therefore
, the greater the owner’s return.
 Generally minimizing the WACC allows management to
undertake a large number of profitable projects, thereby
increasing the value of the firm.
1.4.1 EBIT/EPS Analysis
Assume that there are 3 possible financing mixes for
ABC Company.
Cont…d
 The EBIT-EPS approach to capital structure
involves selecting the capital structure that
maximizes EPS over the expected range of
EBIT.
 The main emphasis is on the effects of various
capital structures on owners’ returns.
 Eg. Assume that plan B is the existing capital
structure for ABC CO. Furthermore , EBIT is
expected to be Br 20,000 per year for a very
long time.
 An inv’t is available to ABC that will cost Br
Cont…d

The firm has two options to raise the needed cash

by:
1. Selling 500 shares of C/S at Br 100each

2. Selling new bonds that will net the firm Br

50,000 and carry an interest rate of 8.5%

3. Assume tax rate 50%

These capital structures and corresponding EPS

amounts are summarized in the following table.
Cont…d
Part A: Capital structures
Cont…d
Part B: Projected sales
Cont…d

 At the projected EBIT level of Br 30,000, the

EPS for the common stock and debt
alternative are Br 6.50 and 7.25
respectively.
 Both are considerably above the Br 5.33 that
would occur if the new project were rejected
and additional financial capital were not
raised.
 Based on the criterion of selecting the
financial plan that will provide the highest
EPS, the bond alternative is favored.
1.5 Introduction to the theory of Capital
Structure

 Modern capital structure theory began in 1958, when

Professors Franco Modigliani and Merton Miller
(hereafter MM) published what has been called the most
influential finance article ever written.
 They demonstrated a formal model that showed why-in
a taxless world-there would be no preference for debt
financing by the firm, and thus, no optimal capital
structure.
 Their analysis was built on a set of assumptions: no
corporate taxes, perfect capital markets and
homogeneous expectations by investors.
1.5.1 M&M propositions I and II with no
taxes

A) M &M proposition I with no taxes

 Capital structure that a firm chooses does not
affect its value.
 Imagine two firms that are identical on the left-
hand side of the financial position. Their assets and
operations are the same.
 Essentially, a company’s physical assets are the
real creators of value and that is simply
reshuffling paper claims to the income produced by
these assets does not add value.
 Firm value is, therefore, independent of financial
leverage.
Cont…d

Thus, proposition I with no tax states:

VL=Vu
Where; VL= value of a firm with financial leverage(debt)-levered firm
VU=value of a firm with no financial leverage-unlevered firm
Eg. An all equity firm has a market value of $300,000 and
50,000shares outstanding. It is thinking of changing its capital structure
by borrowing $120,000 in debt and repurchasing shares(ignore taxes).
Implications:
 Share price is constant

 WACC is constant

 Value of the firm is constant

B) M &M proposition II with no taxes
Although changing the capital structure of the firm may not
change the firm’s total value, it does cause important
changes in the firm’s debt and equity.
 One way interpreting the WACC is that it is the required
return on the firm’s overall assets.
Ke= WACC +(WACC-Kd) *(D/E)
 Return /cost of equity (ke) depends on three things: the
required rate of return on the firm’s assets(WACC), the
firm’s cost of debt and the firm’s debt/equity ratio.
 A firm’s equity capital is a positive linear function of
capital structure.
 MM Proposition II: rS = r0 + B/S (r0 - rB)...

 Example:
 A Co. has a weighted average cost of capital (ignoring taxes)
of 12%. It can borrow at 8%. Assuming that the Co. has a
target capital structure of 80% equity and 20% debt, what is
its cost of equity? What is the cost of equity if the target
capital structure is 50% equity? Calculate the WACC using
your answers to verify that it is the same.
 According to MM II, the cost of equity, RE, is: RE = RA +
(RA − RD ) × (D / E )
 In the first case, the debt-equity ratio is .2/.8 = .25, so the
cost of the equity is: RE = .12 + (.12 − .08) × .25 = .13, or
13%.
- In the second case, verify that the debt-equity ratio is 1.0, so the
cost of equity is 16%. RE = .12 + (.12 − .08) × 1.0 = .16, or 16%.
- Now calculate the WACC assuming that the percentage of equity
financing is 80%, the cost of equity is 13%, and the tax rate is zero:
WACC = (E / V) × RE + (D / V) × RD = .80 × .13 + .20 × .08 = .12, or 12%
- In the second case, the percentage of equity financing is 50% and
the cost of equity is 16%. The WACC is: WACC = (E / V) × R E + (D / V) ×
RD = .50 × .16 + .50 × .08 = .12, or 12%
- As calculated, the WACC is 12% in both cases.
Cont…d

Unlevered Levered
-Share price is constant -Share price is
constant
-Equity less risky -Return on
equity increases
with more
leverage.
1.5.2 M &M propositions I & II with taxes

 Considers the effect of corporate taxes.

 Two firms firm U(unlevered firm) firm L(levered firm)

which are identical on the left-hand side of the financial

position and their operations are the same.
Eg. Assume that EBIT is expected to be Br 2,000 every
year forever for both firms. The difference b/n them is that
Firm L has issued Br 3,000 worth of perpetual bonds on
which it pays 10% interest each year. The interest bill is thus
0.1 *Br 3,000=Br 300 every year forever. Also assume that
the corporate tax rate is 40%.
The interest tax shield

Assuming that depreciation is zero, no addition to

NWC, cash flow from assets is simply equal to EBIT-
taxes. For Firms U and L….
Cash flow from assets Firm U Firm L
EBIT Br 2,000 Br 2,000
Less: taxes 8,00 680
Total 1,200 1,320
From this we can see that capital structure is
having some effect b/c cash flows from U and L are
not the same even though the two firms have
identical assets.
Cont…d
 The total cash flow to the levered Firm L is Br
120 greater. This occurs b/c L’s tax bill is Br
120 lesser owing to the tax shield obtained
from interest on debt.
 Interest is deductible for tax
purposes(generate tax saving).
 Tax saving =Interest payments * tax rate
= (Debt * interest rate)* tax rate
 So tax saving is called interest tax shield
(tax saving attained by a firm from interest
expense).
a) M & M Proposition I with taxes
 Assuming the debt to be perpetual, the interest tax
shield becomes a perpetuity. Thus, the levered firm’s
cash flow will be greater than that of the unlevered firm
by the present value of this perpetual interest tax saving.
Levered firm=Unlevered firm +Pv of interest tax shield
VL= Vu +(T*D)
Where;D= the value of debt
T= corporate tax rate
T*D= Present value of the tax shield
Pv of the tax shield = (T* Kd *D)= T* D
Kd
 The value of the firm L, exceeds the value of Firm U by
the present value the interest tax shield(T*D).

Eg1. Assume the cost of capital for Firm U is 12% i.e

unlevered cost of capital and Ku to represent it. Firm U cash
flow is Br1,200 every year forever and the appropriate
discount rate is Ku =12%.
Then,
i. The value of unlevered Firm,Vu, is:
Vu= EBIT(1-T) = Br2000*(1-0.4) =
Br10,000
Ku 0.12
ii. The value of the levered Firm,VL,is:
VL=Vu +(T*D)
=10,000+0.4*3000
= Br11,200
Cont…d

Eg2. A firm is currently unlevered with

1,000,000shares each priced at $50. The firm is
debating of changing it’s capital structure by
taking $20million in debt and repurchasing
shares. It will pay down this debt by $4 million
every year. If the tax rate is 40% and cost of
debt is 8%, What is the value of the
restructured firm?
Cont…d

Eg3. An all equity firm currently has free cash

flows of $10million a year and a cost of equity of
10%. It will take on $30million of debt and
repurchase shares. If the firm only plans to make
interest payments, the interest rate is 6% and
tax rate is 40%, what is the value of the
levered firm?
b) M&M proposition II with taxes

 M&M proposition II with corporate taxes states

that the cost of equity,Ke,is:
Ke=Ku+(Ku-Kd))*(D/E)*(1-T)
Eg1. To illustrate, we saw a moment ago that a Firm
L is worth Br 11,200 total. Since the debt is worh Br
3,000, the equity must worth Br 8,200. Then for Firm
L, the cost of equity is thus:
Ke=0.12+(0.12-0.1)+(3000/8200)*(1-0.4)=12.44%
The WACC is:
=(8,200/11,200)*12.44%
+(3,000/11,200)*10%=11.78%
Cont…d

 In the absence of debt, the WACC is 12% and with

debt, it is 11.78%.
 Therefore, the firm is better off with debt.
 This decrease in WACC is attributable to the lower
cost of equity as a result of the (1-T) tax deduction.
Cont….d

Eg2. A firm has a free cash flows of $20million with

unlevered cost of capital of 10% permanent debt of
50million, cost of debt of 8%, and tax rate of 40%.
Required: What is the WACC of the firm?
Solution:
Step1: Vu= FCF = 20,000,000 = $200,000,000
WACC 0.1
Step2: VL = Vu +Pv of interest tax shield
= 200,000,000+50,000,000*.4
=$220,000,000
Step3: Ke=Ku+(Ku-Kd))*(D/E)*(1-T)
= .1+(.1-0.08)*50/170*(1-0.4)
=10.35294%
Then, WACC= (E/V)*Ke + (D/V)(Kd)(1-T)
= (170/220)*0.1035294+(50/220)(0.08)(1-
0.4)
=9.0909%
Value of the firm =FCF = 20,000,000 =
$220million
WACC 0.090909
M&M propositions and their
implications summary
I. The No-tax case
A. Proposition I: The value of the firm
levered(VL) is equal to the value of the firm
unlevered(Vu).
VL=Vu
 Implications of proposition I
i. A firm’s capital structure is irrelevant
ii. A firm’s WACC is the same no matter what
mixture of debt and equity is used to
finance the firm.
Cont…d
B. Proposition II: The cost of equity,ke,is:
Ke=WACC +(WACC-Kd)*(D/E)
Where, Kd is the cost of debt, and D/E debt to equity
ratio.
Implications of proposition II
i. The cost of equity rises as the firm increases its use of
debt financing.
ii. The risk of equity depends on two things: the riskiness
of the firm’s operations(business risk) and the degree
of financial leverage(financial risk).
II. The tax case
A. Proposition I with taxes

The value of the firm levered(VL)is equal to the value of

the firm unlevered (Vu) plus the present value of the
interest tax shield: VL= Vu+T*D
Implications of Proposition I
i. Debt financing is highly advantageous and in the
extreme a firm’s optimal capita structure is 100% debt.
ii. A firm’s WACC decreases as the firm relies more
heavily on debt financing.
B. Proposition II with taxes
Ke= Ku+(Ku-Kd)*(D/E)*(1-T)
 Where Ku is the unlevered cost of capital,

that is the cost of capital for the firm if it had

no debt.
 Unlike proposition I, the general implications

of proposition II are the same whether there

are taxes or not.
1.5.3 Trade of theory(static trade-off hypothesis)

 The results of M and M depends on the assumption that

there are no bankruptcy costs.
 As the use debt increases the interest tax shield benefit
to owners also increases , it also simultaneously
increases the cost of and risk of bankruptcy.
 Thus, one limit to the amount of debt a firm might use
comes in the form of bankruptcy costs.
 As the debt/equity ratio rises, so too does the
probability that the firm will be unable to pay its
bondholders what was promised to them.
Cont…d
 Bankruptcy-related problems are most likely to arise
when a firm includes a great deal of debt in its capital
structure.
 Thus, bankruptcy costs discourage firms from pushing

their use of debt to excessive levels.

 Bankruptcy-related costs have two components:

i. the probability of (bankruptcy ) financial

distress
The expected cost of bankruptcy to a company
depends on two things:
a. the probability that a bankruptcy will occur and
b. the cost if it does occur.
 Cont…d
ii. The cost of bankruptcy- could be
classified into two.
a. Direct bankruptcy costs – when a firm is
economically bankrupt (net worth),
ownership of the firm passes over to the
creditors.
Eg. legal and administrative costs to
bankruptcy.
b. Indirect bankruptcy costs-
 When a firm is having significant problems in

meeting its debt obligations, it is

Cont…d

 Thus, static theory of capital structure say that

firms borrow up to the point where the tax benefit
from an extra dollar in debt is exactly equal to the cost that
comes from the increased probability of financial distress.
 It assumes that the firm is fixed in terms of its assets and
operations and it only considers possible changes in the
debt/equity ratio.
 In essence, the trade-off theory says that the value of a
levered firm is equal to the value of an unlevered firm plus
the value of any side effects, which include the tax shield
and the expected costs due to financial distress.
Cont…d
 Then, as a result of countervailing
forces of the tax deductibility of interest
and expected bankruptcy costs, there is
an optimal capital structure.
VL=Vu +(PV of ITS) –(PV of expected
bankruptcy costs)
 As leverage increases, the PV of ITS

increases, but the PV of expected costs

decline.
A summary of the trade-off theory is expressed graphically

i. Under the assumptions of the MM model with corporate

taxes, a firm’s value increases linearly for every dollar of

debt. The line labeled “MM Result Incorporating the Effects

of Corporate Taxation” in the above Figure expresses the

relationship between value and debt under those

assumptions.
ii. There is some threshold level of debt, labeled D1 in the
above Figure , below which the probability of bankruptcy is so
low as to be immaterial. Beyond D1, however, expected
bankruptcy-related costs become increasingly important, and
they reduce the tax benefits of debt at an increasing rate. In the
range from D1 to D2, expected bankruptcy-related costs reduce
but do not completely offset the tax benefits of debt, so the stock
price rises (but at a decreasing rate) as the debt ratio increases.
 However, beyond D2, expected bankruptcy-related costs
exceed the tax benefits, so from this point on increasing the
debt ratio lowers the value of the stock.
 Therefore, D2 is the optimal capital structure. Of course, D1
and D2 vary from firm to firm, depending on their business
risks and bankruptcy costs.
 1.5.4 Pecking order theory
 Firm prefer to use internal financing where possible.
 Profitable firm do not need external financing.
 POT-states the order in which projects(firms’ raised
required capital)should be funded.

1. Use net income or retain earnings of company.

2. The firm will issue debt(bonds).

3. The firm will issue stocks

1.5.5 Signaling theory
 MM assumed that investors have the same
information about a firm’s prospects as its
managers—this is called symmetric
information(investors and managers have
identical information about firms’ prospects.)
 However, in fact managers often have better
information than outside investors.
 Then, ST is generally concerned with the reduction
of information asymmetry between two market
actors.
 Signal is an action taken by a firm’s
management that provides clues to investors about
how management views the firm’s prospects.
 a firm with very favorable prospects to try to avoid
selling stock and, rather, to raise any required new
capital by other means, including using debt beyond the
normal target capital structure.
 A firm with unfavorable prospects would want to sell
stock, which would mean bringing in new investors to
share the losses.
 management would want to issue stock if things looked
bad.
 In a nutshell, the announcement of a stock offering is generally taken as a
signal that the firm’s prospects as seen by its management are not bright.
 This, in turn, suggests that when a firm announces a new stock offering,
more often than not, the price of its stock will decline.
 Then what are the implications of all this for capital structure
decisions? Since issuing stock emits a negative signal and thus tends to
depress the stock price, even if the company’s prospects are bright, a firm
should, in normal times, maintain a reserve borrowing capacity that can
be used in the event that some especially good investment opportunity
comes along.
 Reserve Borrowing Capacity – is the
ability to borrow money at a reasonable cost
when good investment opportunities arise.
Firms often use less debt than specified by
the MM optimal capital structure in “normal”
times to ensure that they can obtain debt
capital later if they need to.
1.5.6 USING DEBT FINANCING TO CONSTRAIN
MANAGERS

 agency problems may arise if managers and

shareholders have different objectives. Such
conflicts are particularly likely when the firm’s
managers have too much cash at their disposal.
 Managers often use such cash to finance their
pet projects or for perquisites such as nicer
offices, corporate jets, and sky boxes at sports
arenas, all of which may do little to maximize
stock prices.
 By contrast, managers with limited “free cash
flow” are less able to make wasteful
expenditures.
Firms can reduce excess cash flow in a
variety of ways.
 One way is to funnel some of it back to
shareholders through higher dividends or stock
repurchases.
 Another alternative is to shift the capital
structure toward more debt in the hope that
higher debt service requirements will force
managers to become more disciplined.
 If debt is not serviced as required, the firm will

be forced into bankruptcy, in which case its

managers would likely lose their jobs.
 Therefore, a manager is less likely to buy an
expensive new corporate jet if the firm has
large debt service requirements that could
cost the manager his or her job.
 In short, high levels of debt bond the cash
flow, since much of it is precommitted to
servicing the debt.
END OF CHAPTER ONE