Chapter 7
Leverage and Capital Structure
Leverage – portion of a business’s fixed cost
that represents a risk to the firm
 Operating Leverage – measure of
operating risk
- Fixed operating costs found in the
income statement
 Financial Leverage – measure of
financial risk
- Long term financing with fixed
financing charges of business’s
assets
- Higher financial leverage = higher
financial risk and higher cost of
capital
* Optimal structure for any business enterprise
depends to a great extent on the amount of
leverage the business can tolerate and the
resultant cost of capital
S – Sales
x – Sales Volume per Unit
p – Selling Price per Unit
v – Unit Variable Cost
VC – Variable Operating Cost
FC – Fixed Operating Cost
A. Break-even Analysis – closely related to
operating leverage
- Determines *break-even sales
[*financial crossover point at which
revenue exactly match costs]
- Important Concepts
 Contribution Margin (CM)
amount of money available to cover
fixed cost (FC) and generate profits
- excess of sales (S) over the
variable cost (VC)
= S – VC
 Unit CM – excess of unit selling price
(p) over the unit variable cost (v)
=p–v
a. Break-Even Point – level of sales
revenue that equals to the total of
variable and fixed costs for any given
volume of output at a particular capacity
use rate
- Lower BEP = higher profits and less
operating risk
- Break-Even Points in Units = fixed
cost DIVIDED BY unit CM
b. Cash Break-Even Point – necessary
sales to cover all cash expenses during
the period
- Not all fixed operating cost involve
cash payment (e.g. depreciation)
- Usually lower than break-even point
= fixed cost MINUS non-cash
charges
= (fixed cost MINUS depreciation)
DIVIDED BY unit CM
B. Operating Leverage – measure of
operating risk
- Arises from the business’s use of fixed
operating cost
- Simple indication = impact of a change
in sales on earning before interest and
taxes (EBIT)
- Operating Leverage at a given
Level of Sales (x) = percent change in
*EBIT DIVIDED BY percent change in
sales
( p−v ) x
=
( p−v ) x−FC
- *EBIT = (p-v) x - FC
C. Financial Leverage – measure of financial
risk
- Arises from the presence of debt and/or
preference share capital in business’s
capital structure
- way to measure: determine how earning
per share (EPS) are affected by a change
in EBIT
- If EBIT falls = financially leveraged
business will experience negative
changes in EPS that are larger than
relative decline in EBIT
- Preference share divided must be
– adjusted for tax
- Financial Leverage at a given Level
of Sales (x) = percent change in EPS
DIVIDED BY percent change in EBIT
( p−v ) x−FC
=
( p−v ) x−FC−I
* I = fixed finance charges
Total Leverage – measure of total risk
- To measure: determine how EPS is
affected by a change in sales
- Total Leverage at a given Level of
Sales (x)
= percent change in EPS DIVIDED BY
percent change in sales
= operating leverage MULTIPLIED BY
financial leverage
( p−v ) x ( p−v ) x −FC
= ×
( p−v ) x−FC ( p−v ) x−FC −I
( p−v )x
=
( p−v ) x−FC −1
Tools of Capital Structure Management
* Capital Structure Management – mix of
long-term funding source used by business
- To maximize market value of business
- Optimal Capital Structure – mix,
minimizes the overall cost of capital
o Not all financial managers believe that
this actually exists
o May allow a higher portion of debt to
equity than actual industry average =
justify more debt than industry
- Decision to use debt and/or preference
share in capitalization results in two types of
financial leverage effect
i. Increased risk to EPS caused by the use
of financial obligations
ii. Relates to the level of EPS at a given
EBIT under a specific capital structure
- Tools
1. EBIT-EPS Analysis – practical tool that
enables financial managers to evaluate
alternative financing plans by investing
their effect on EPS for a range of EBIT
levels
- Primary objective: determine the EBIT
break-even or indifference points at
which the EPS will be the same
regardless of the financing plan
- EBIT amount > EBIT indifference level
= more highly leveraged financing
plan will generate higher EPS
- EBIT amount < EBIT indifference level
= financing plan involving least
leverage will generate higher EPS
= 2. Competitive structure in the industry
(EBIT −I )(1−t)PD ( EBIT −I )(1−t) PD
= 4. The business risk which the firm is exposed
S1 S2
2. Analysis of Cash Flow – to determine
the ability to service fixed charges
- Greater peso amount of debt and/or
preference share capital the business
issues and the shorter their maturity
= greater fixed charges the business
will have to bear
- Before assuming additional charges,
business should analyze its future
expected future cash flows
o Inability to meet future charges =
insolvency
- Greater and more stable expected
future cash flow = greater debt
capacity
3. Calculation of Comparative
Coverage Ratio – corporate financial
officer typically uses as EBIT as a rough
measure of the cash flow available to
cover debt-servicing obligation
- Can be used for two types of
comparison
i. Can compare past and expected
future ratios for the same
business in order to determine if
there has been improvement or
deterioration in coverage over
time
ii. To evaluate capital structure of
other businesses in the same
industry
- Common Ratios
a. Time Interested Earned – most
widely used comparative ratio
- Reveals nothing about
business’s ability to meet
principal payments on its debt
= EBIT DIVIDED BY interest on
debt
b. Debt-Service Coverage –
coverage ratio for full debt-service
burden
EBIT
= Principal Payments
Interest 1+
1−Tax rate
* Financial risk associated with leverage should
be analyzed of the business’s ability to service
total fixed charges
* Lease financing is NOT a debt, but it has
same impact on cash flow.
Factors that Influence Capital Structure
1. Growth rate and stability of future sales
3. Asset makeup of individual firm
5. Control status of owners and management
6. Lenders’ attitudes toward the industry and
the business
Factors that Affect the Level of Target
Debt Ratio
Main: Business’s ability to service fixed
financing costs
Other:
a. Maintaining a desired bond rating
b. Providing an adequate borrowing reserve
c. Exploiting the advantages of financial
leverages