Financial Management

Note: Capital Structure and Leverage (Financing Decision)

CAPITAL STRUCTURE
A corporation uses two types of funds that are long term capital and short term financing sources. Long
term capital is the mixture of share capital, capital reserves, long term debt capital and loans taken from
financial institutions. In the business term the mixture of long term sources is known as capital structure.
On other hand, the mixtures of current liabilities are short term sources of financing. If we combine the
long term sources of financing and short term sources of financing it is called financial structure of the
corporation shows financing and investment decisions. Financing decisions consists of liability and
equity side of the balance sheet. Matching financing and investment decisions is necessary to achieve
corporation goal. The corporation necessary is to achieve operation goal. The corporation should make
proper decision for raising long term capital because it is raised for investment decision purpose. We
classify long term capital structure. The equity capital consists of equity share capital, additional paid in
capital reserves and surplus, preference share capital etc. Whereas, debt capital consists of Bond,
debentures, borrowings from different institutions. So the capital structure is the mixture of debt and equity
capital in the corporation. The proportion of debt and equity capital depends upon the nature and performance
of the business organization. So target of capital structure vary according to corporations. Making proper
combination of debt and equity is difficult task for a financial manager. Use of proper debt and equity according
to performance of the corporation is necessary to maximize firm's wealth. Every corporation tries to see its
capital structure at proper level or optimal level. So, optimal capital structure us such mixture of debt and equity
capital which maximizes price of the stock and minimizes overall cost of capital of the corporation. We can
illustrate the concept of financial structure and capital structure of the corporation with the help of following
balance sheet:

Assets Rs. Liability and equity Rs.

Cash 100,000 A/C payables 150,000
A/C receivables 200,000 Accruals 100,000
Inventory 200,000 Notes payable 150,000
Total Current assets 500,000 Total current liabilities 400,000
Net Fixed Assets 500,000 Long term debt 200,000
Common stock 300,000
Retained earnings 100,000
Total Assets 1,000,000 Total liability & equity 1,000,000
In above balance sheet, financial structure refers all components of the liability and equity side where as
capital structure consists the components except current liabilities. So, we can conclude that financial
structure is broad concept but capital structure is the part of financial structure. Finally the financial
structure of corporation shows collection of fund from different sources where as assets side shows
investment decision of that collected fund. So, the assets side and liability sides always equal figures.
The mathematical equation for capital structure and financial structure can be expressed as follows:
Derived from Book – Corporate Finance (Benchmark Education Support) Page 1
 Financial structure = Long term debt and Preferred stock + equity + current liabilities
Capital structure = long term debt and Preferred stock + equity
Alternatively,
Capital Structure= Financial Structure- Current Liabilities
MAKING OPTIMAL CAPITAL STRUCTURE
The business organization or corporation can make different combinations of debt and equity for its capital
structure purpose. If firm uses only equity capital the firm is called unlevered firm whereas if firm debt and
equity capital in capital structure it is called levered firm. Use of debt capital brings some benefits as well as risk.
If firm uses more debt capital it reduces tax liability of firm and it has fix cost of interest to bond holders. In other
hand if firm went in loss or lower profit the regular payment of interest is burden to the company. So the firm
should make optimal capital structure among different combination of debt and equity that maximizes price of
stock and minimizes weighted average cost of capital. The alternative capital structures are mentioned in the
following table:

Debt Equity Weight of debt (Wd) Weight of Equity (We)

0 100 0 1
20 80 0.2 0.8
40 60 0.4 0.6
50 50 0.5 0.5
80 20 0.8 0.2
100 0 1 0
Above table shows different combination of debt and equity capital the firm can make. Use of more or
less debt capital depends upon business risk, tax status, financial distress, costs, fluctuation in earnings
etc. If firm have high operating costs as well as fluctuation in earning it should use less debt capital
where as if firm regular stable has or growing pattern earning. It can increase the level of debt capital.
Besides that the firm should match its capital structure weights with the weighted average cost of
capital. The WACC can be influenced varying proportion of debt and equity capital. WALL is calculated
by following formula:
WACC = Wd x Kdt + We x ke
Where,
Wd = Weight of debt
Kdt = After tax cost of debt
We = Weight of equity
Ke = Lost of equity
Suppose ABC Company is considering following capital structure weights with their component costs for optimal
capital structure determination.

Wd We kdt ke WACC=Wd x kdt+We x ke

Derived from Book – Corporate Finance (Benchmark Education Support) Page 2
 0 1 8% 10% 10%
0.2 0.8 8% 10% 9.6%
0.4 0.6 8% 10% 9.2%
0.5 0.5 10% 12% 11%
0.8 0.2 12% 13% 12.2%
1 0 14% 13.5% 14%
In above situation if firm has to set the target capital structure the ratio of 40% debt and 60% equity is
the optimal capital structure which minimized the weighted average cost of capital (WACC). The lower
WACC for a corporation reduces risk and increases profitability.
FACTORS AFFECTING CAPITAL STRUCTURE DECISION
The capital structure decision mainly depends upon the nature of the business organization. But the firm
should consider following internal and external factors while making capital structure decisions.
1. Size of Corporation
Large size firm can easily collect funds as compare to small firm because their debt security can
easily sold in capital market at lower interest rate due to their creditability and goodwill. So, large
firm uses more debt as compare to small firm.
2. Sales stability
The firms having stable sales can use more debt than others due to their regular revenue that covers
the interest paying capacity.
3. Profitability
The firm running in higher return has not necessary to use more debt because it can use yearly
income for business enhancement or financing requirements.
4. Growth in Sales
The firm's with significant growth in sales might prefer equity financing because their stock price is
generally higher.
5. Operating Leverages
The capital structure is also affected by use of fixed costs. High operating leverage increases risk in
the organization. So the organization having higher operating leverage is suggested to use low debt.
6. Tax Status
If corporate tax is higher the use of debt capital is beneficial because interest expenses are deductible
before the tax adjustment.
7. Assets Structure
The capital structure of the firm is affected by asset held. If firm has more long-term assets or fixed
assets it uses long-term debt where as if firm has more current assets it uses short term financing.

Derived from Book – Corporate Finance (Benchmark Education Support) Page 3

 8. Business Risk
If the firm has not stable earning there is chance of business risk. The company having more
business risk should reduce level of debt capital in its capital structure.
9. Control
The corporation should prefer for raising debt capital if wants to keep control in existing
management. But if the financial position of corporation is not sound it should raise fund from
equity capital so control aspect determines use of debt and equity capital.
10. Lender's Attitude
The use of more debt financing depends upon attitude of existing lenders of firm. If firm tries to use
more debt it brings risk to existing lenders as well as reduces credit rating of the firm.
Furthermore the capital structure decisions is affected by stability of cash flow, management
attitudes, market conditions, legal requirements, nature of the business industry etc.
LEVERAGE
Generally, the term leverage is associated with use of debt capital in the capital structure. Furthermore
leverage shows firm's ability in using long-term funds bearing fixed costs that affects profitability.
Commonly a firm having higher leverage increases level of risk as well as profitability and vice versa.
So, the leverage measures effect of change in one variable to another. Leverage can be classified as
follows:
a) Operating Leverage
The operating leverage shows affect of fixed operating cost on the profitability. Fixed operating costs are
such costs which must bear by firm at any production level. The impact of operating leverage on firm
depends upon operating level or sales volume. Degree of operating leverage (DOL) is change in
operating leverage due to change in sales. So, the DOL shows affect of fixed cost on the profit of firm.
The DOL can be minimized by minimizing fixed cost of the firm. It means there is positive relationship
between fixed cost and DOL and vice-versa. It can be calculated as follows:
% change in EBIT
DOL = % change in sales

Alternatively,
When only one years' data is available
contribution margin
DOL = =Q(SPPU_VCPU)/Q(SPPU_VCPU)-FC
EBIT
Q
or Q - BEP in units

Where,
Q = Sales or production quantity other than BEP quantity
SPPU= selling price per unit

Derived from Book – Corporate Finance (Benchmark Education Support) Page 4

 VCPU= Variable cost per unit
FC= Fixed Cost.
Note: If DOL is 2 times it indicates if sales change by 1% then the EBIT will change by 2%.
b) Financial Leverage
The financial leverage shows affect of fixed financing cost on the profitability. Fixed financing costs are
caused by use of debt capital and preference share capital such as interest expenses and dividend paid to
preference share holders. The impact of financial leverage on firm depends up on volume of debt and
preference share capital. Degree of financial leverage (DFL) shows change in earning before tax or
earning per share due to change in earnings before interest and tax. So the DFL shows affect of fixed
financing costs on the profitability. Higher DFL shows higher financial risk on the firm. DFL can be
minimized by minimizing fixed financing costs.It means, higher the financial charges(ie,interest and
preference dividend) higher will be the DFL and vice-versa.It can be calculated as follows:
% change in EBT or EPS
DFL = % change in EBIT

Alternatively,
When only one years' data is available
If there is no preferred stock
EBIT
DFL=
EBT
If preferred stock is given
EBIT
DFL = PD
EBT -
1- t
Where,
PD = Preferred stock dividend
t = Tax rate IN Re. 1.
Note: If DFL is 3 times it indicates if EBIT change by 1%, then EBT or EPS will change by 3%.
c) Combined or Total Leverage:
It is the product of DOL and DFL. The combined leverage is the measurement of risk caused by fixed
operating costs and fixed financing cost together. It shows impact on profitability due to total fixed costs
of the firm. In other word combined leverage is the combination of DOL and DFL. If the measure
impact of both risk together, the small change in sales volume shows large change in EPS of the firm.
The Degree of Combined (DCL) leverage measures change in EBT or EPS due to change in sales. DCL
can be minimized by minimizing DOL and DFL. It can be calculated as follows:
DCL = DOL*DFL

Derived from Book – Corporate Finance (Benchmark Education Support) Page 5

 % change in EBT or EPS
Or, DTL = % change in Sales

When only one years' data is given,

If preferred stock is not given,
Contribution margin
DTL=
EBT
If preferred stock is given
Contribution margin
DTL= PD
EBT -
1- t
Note: If DCL is 6 times it indicators, if sales change by 1% then EBT or EPS will change by 6%.
BUSINESS RISK
Business risk is the uncertainty on the profitability due to change business factors rather than leverage
impact. In other word, business risk is measured with assuming firm has no debt capital. Business risk
can be reduced by improving operating capacity of the firm. Business risk appears when uncertainty
comes to prediction for return on invested capital. Return on invested capital is calculated using
following formula:
Net operating profit after tax
Return in interest capital = Total capital

If there is no debt capital used then capital consist only equity and the interest becomes zero and return
on invested capital is equivalent to Return on equity.
Net Income
Return on equity = Total equity

 Busines risk of firm is associated with following factors:

i) Change in Demand
Firm's income depends upon demand of its product in the market. So a firm having large change in
demand exposed to business risk.
ii) Change in Selling Price
If selling price of firm's product is differing time to time it may change the profitability. So the products
having changeable price has more business risk as compare to stable price products.
iii) Change of input lost
The firm which has changeable input lost or production cost is exposed to business risk. If production
cost is increased the profitability is decreased.
iv) Technological Changes
If firm cannot update technological changes it can lose the demand if product and profitability is
reduced.
Derived from Book – Corporate Finance (Benchmark Education Support) Page 6
 v) Effect of Operating Leverage
If firm has larger fixed costs the profitability is sensitive to sales. It means firm should make more sales
to meet fixed operating costs.
vi) Price Adjustment Capacity
If firm cannot increase it's selling price whenever input cost rises there is chance of business risk but if
firm can adjust selling price according to input cost it has lower business risk.
FINANCIAL RISK
Financial risk is the extra risk to equity shareholders due to the use of debt capital and preference share
capital. So if firm does not use debt or preference share capital there is no any financial risk. Use of
more debt capital can increase or decrease equity share holders return because interest on debt and
dividend on preference share capital are determined. A corporation should meet such expenses at any
profitability conditions. So using more debt capital or preference share capital increases financial risk of
the corporation.
OPERATING BREAKEVEN
Operating breakeven is also known as accounting breakeven or breakeven point. It is the level of sales at
which total sales revenue and total operating costs are equal. In other word at this sales level operating
profit (EBIT) becomes zero. The total operating cost is the combination of variable operating cost and
fixed operating cost. Variable operating costs increase or decrease according to production level but
fixed operating cost remains unchanged at certain level of production. Contribution margin is the
difference between sales revenue and variable costs, that shows profit available to recover fixed
operating cost and it is changed in sales level. The operating breakeven can be expressed as following:
Sales revenue = Total operating costs
or, SxQ = fc + Vc
or, SxQ = fc + V x Q
or, S x Q - V x Q = fc
or, Q(S - V) = fc
fc
or, Q = (Breakeven quantity)
S-V
Breakeven point in rupee can be calculated as follows:
fc
BEP in rupee = BEP in units x S or, Contribution margin ratio

Where,
S = Selling price per unit
V = Variable cost per unit
fc = Fixed operating costs

Derived from Book – Corporate Finance (Benchmark Education Support) Page 7

 Q = production or Sales quantity
Conribution margin
Contribution margin ratio =
Sales
Conribution margin per unit
or Selling price per unit

The concept of operating breakeven can be expressed as following example and graph:
A firm has Rs. 75000 in fixed cost and it sells Rs. 15 per unit and has Rs. 10 per unit variable cost.
fc Rs.75,000
BEP in unit = = = 15,000 units
S-V Rs. 15 - Rs. 10
Sales revenue = S x Q = 15,000 x Rs. 15 = Rs. 225,000
Total cost at this quantity = fc + Vc
= Rs. 75,000 + 15,000 x Rs. 10
= Rs. 225,000
BREAKEVEN GRAPH
Revenue & Costs Total revenue
y Total operating cost
Rs. 250,000
Breakeven
Rs. 200,000 Point

Rs. 150,000

Rs. 100,000
fc
Rs. 50,000

x
5,000 10,000 15000 20000 25000
Production Quantity

In above graph, x-axis represents level of production and y-axis represents sales revenue and costs. At
15000 productions level the total sales revenue line cuts the total operating cost line, which is the
breakeven point or zero operating profit situation. So if firm produces more than 15000 units the
revenue will exceed total operating cost and it can make profit but below the 15000 units firm has to
bear loss. So this analysis provides guideline to set production level and making control policy for costs.

INDIFFERENCE POINT OR EBIT - BREAKEVEN POINT

Indifferences point is that level of earnings before interest and taxes (EBIT) at which the earnings per
share (EPS) is the same for tow alternative financial plans. It is is the level of EBIT beyond which the
benefits of financial leverage begin to operate with respect to EPS. Thus, if the expected level of EBIT is
to exceed the indifference level be advantageous from EPS point of view. The indifference point
between two methods of financing can be determined by means of following equation.

Derived from Book – Corporate Finance (Benchmark Education Support) Page 8

 EBIT - I1 (I - t) - Pd1 EBIT - I 2 (I - t) - Pd 2
=
1 2
Where, I1 = Interest under plan I
I2 = Interest under plan II
Pd1 = dividend under plan I
Pd2 = dividend under plan II
N1 =Number of common shares under plan II
T = tax rate
EBIT = The EBIT indifference point between the two methods of financing
Example
B&B company required Rs. 20,00,000 in next year. Following are the two feasible financial plans.

Financial plan I II
Equity shares of Rs. 100 each Rs. 20,00,000 10,00,000
8% Debentures 10,00,000
Total 20,00,000 20,00,000
Required:
(I) calculate the indifference point of EBIT assuming 50% tax rate.
(II) Which plan is profitable if Jyoti Company’s EBIT is Rs. 200,000?
(III)Which plan is profitable if Jyoti Company’s EBIT is Rs. 120,000?
Solution,
(I) Here,
2,000,000
N1 = = 20,000 shares
100
100
1,000,000
N2 = = 10,000 shares
100
100
I1 =0
I2 = 8% of Rs. 10,00,000 = Rs. 80,000
Tax rate = (T)
Calculation of indifference point of EBIT

(EBIT-I1 ) ( 1-T) -pd1 = (EBIT-I2) (1-T) - Pd2

N1 N2
(EBIT-0) (1-0.5) -0 (EBIT- 80,000) (1-0.5 ) -0
20,000 10,000

0.5EBIT = 0.5EBIT -40,000

2 1
EBIT - 80,000 = 0.5EBIT
1BIT -0.5EBIT = Rs. 80,000
0.5EBIT = Rs. 80,000

Derived from Book – Corporate Finance (Benchmark Education Support) Page 9

 0.5
: EBIT = Rs. 160,000

Verification: calculation of EPS under two plans

Particulars Financial plan I Financial plan

II
EBIT (indifference) Rs. 160,000 Rs. 160,000
Less : interest (I) 0 80,000
EBT 160,000 80,000
Less: tax @ 50% 80,000 40,000
EAT 80,000 40,000
Less : pd 0 0
Earning available to equity shareholders ) 80,000 40,000
No. of common shares (N) 20,000 10,000
EPS = EAES Rs. 4 Rs. 4
(II) Financial plan

Particulars Financial Financial plan

plan I II
Actual (EBIT) Rs. 200,000 Rs. 200,000
Less : interest (I) 0 80,000
EBT 200,000 120,000
Less: tax @ 50% 100,000 60,000
EAT 100,000 60,000
Less : pd 0 0
Earning available to equity shareholders ) 100,000 60,000
No. of common shares (N) 20,000 10,000
(EPS = EAES ÷N) Rs. 5 Rs. 6
Actual EBIT Rs. 200,000 is greater than indifferent EBIT Rs. 160,000 There fore the less of debt will
produce higher EPs. Thus B&B company should select financial plan II whose EPS is Rs. 6 which is
more than financial plan's EPS of Rs. 5 .
(III) If actual EBIT is Rs. 120,000
(Below indifference EBIT)
plan Plan I plan II
Actual (EBIT) Rs. 12,000 Rs. 120,000
Less : interest (I) 0 80,000
EBT 120,000 40,000
Less: tax @ 50% 60,000 20,000
EAT 60,000 20,000
Less : pd 0 0
Earning available to equity shareholders ) 60,000 20,000
No. of common shares (N) 20,000 10,000
(EPS = EAES ÷N) Rs. 3 Rs. 2

Derived from Book – Corporate Finance (Benchmark Education Support) Page 10

 Actual EBIT Rs. 120,000 is less than indifferent EBIT of Rs. 160,000, there fore the use of debt is not
profitable due to lesser EPS of Rs. 2. In this case the Jyoti8 Company should select financial plan I due
to higher EPS of Rs. 3 per share.
Indifferent point of sales
At this level of sales EPS of both alternative is equal which Rs. calculated as below:
Calculation of indifferent point of sales
sales -VC-FC -I1) (1-T) -Pd1 = (sales -VC-FC-I2) (1-T) -pd
N1 N2

Example
The total assets of X company includes Rs. 50,00,000 and is considering to finance these assets either
50% from debt and rest from equity or 40% from debt and rest from equity . Other information is as
follows.
Fixed cost: (FC) = 10, 00,000
Variable cost = 50% of sales
Interest on debt = 10%
Tax rate = 50%
Per value per share = Rs. 100
Required:
(I) Indifferent point of sales
(ii) Which plan is profitable if actual sales are Rs. 40, 00,000

Here, sales =X
VC= 50% of x =0.5X
I1 = interest on debt under plan I
= (Rs. 50, 00,000 x 50 ) x 10
100 100
= 250,000
I2 = interest on debt under plan II
= (Rs. 50, 00,000 x 40 ) x 10
100 100
= Rs. 200,000
T = 50% = 0.50
N1 (50, 00,000 x 50) ÷ 100
100
= Rs. 250,000 ÷100
= Rs. 250,000 shares
N2 = (50, 00,000 x 60) ÷ 100
100
= 30, 00,000 ÷100
= 30,000 shares

Derived from Book – Corporate Finance (Benchmark Education Support) Page 11

 Calculation of indifference point of sales
(X-VC-FC- I1) )( 1-T) -Pd1 = (X-VC-FC-I2) (1-T) -Pd2
N1 ` N2
(X-0.5X-150,00,000- 250,000 ) (1-0.5) = (X-0.5X-10,00,000-200,000) (1-0.5) -0

2500 30,000
0.25X -625000 = 0.25X - 600,000
5 6
1.5X-3750000 = 1.25X -30, 00,000
1.5X-1.25X = 3750.000- 30, 00,000
0.25X = 750,000
X = 750,000
0.25
= Rs. 30, 00,000
Indifference point of sales is Rs. 30, 00,000. At this point of sales EPS under both alternative is equal
(I.e. Rs. 5)
plan plan I plan II
(50% from debt & 50% (40% from debt
equity ) & 60% equity
sales Actual Rs. 40,00,000 Rs. 40,00,000
Less : VC 50% of sales) 20,00,000 20,00,000
CM 20,00,000 20,00,000
Less: FC 10,00,000 10,00,000
EBIT 10,00,000 10,00,000
Less : interest 250.000 200,000
EBT 750,000 800,000
Less: tax @ 50% 375000 400,000
EAT 35700 400,000
Less: pd 0 0

EAES 375000 40,000

No. of shares (N) 25000 30,000

EPS = EAES Rs. 15 Rs. 13.33
N
Actual sales Rs. 40, 00,000 is more than indifference point of sales of Rs. 30, 00,000 therefore more
amount of debt financial is profitable. Under Ist plan EPS is Rs. 15 which is more than EPs of 2 nd plan.
Therefore 1ST plan is profitable than 2nd plan.

Derived from Book – Corporate Finance (Benchmark Education Support) Page 12