Capital Structure and Leverage

* Capital Structure and Leverage

• Companies can finance with either debt or equity.

• Is one better than the other?
• If not then,
• What is the optimal mix?
 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
What is Leverage?

• 1. The use of various financial (debt) instruments or borrowed

capital, to increase the potential return of an investment. 

2. The amount of debt used to finance a firm's assets. A firm with

significantly more debt than equity is considered to be highly
leveraged.

3.The degree/extent to which an investor or business is utilizing

borrowed money.
*Target Capital Structure
• It is the mix of debt, preferred stock and common equity with which the
firm plans to raise capital.
• Using more debt raises the risk borne by stockholders- because S.H will
have to make short falls if losses occur.
• However, using more debt generally leads to a higher expected rate of
return on equity- because int. is tax deductible

• Higher risk tends to lower a stock’s price, but a higher expected rate of
return raises it. (trade off)
• Therefore the optimal capital structure must strike a balance between
risk and return so as to maximise the firm’s stock price and
simultaneously minimise the cost of capital.
*Primary Factors that influence C.S

T.C.S may change over time as condition / factors change.

• Business Risk
• Tax position
• Financial flexibility
• Managerial conservatism or aggressiveness
Business Risk
• Uncertainty about future operating income (EBIT), i.e., how well can we
predict operating income?
• ROIC=NOPAT/Capital
= Net income to common stock holders+ After tax interest payments /
capital
ROIC (zero debt)= ROE=Net income to common stock holders/common
equity

ROIC= return on invested Capital

NOPAT=Net Operating Profit after taxes
DISCUSSION QUESTION: 
 BUSINESS RISK VARIES FROM INDUSTRY TO INDUSTRY AND FIRMS TO FIRMS. WHY?
 

FACTORS CONTRIBUTING TO BUSINESS RISK:

 
DEMAND VARIABILITY:
 
THE STABLE THE DEMAND FOR A FIRM’S PRODUCTS, OTHER THINGS BEING
CONSTANT THE LOWER THE BUSINESS RISK
 
SALES PRICE VARIABILITY:
 
PRODUCTS THAT ARE SOLD IN HIGH VOLATILE MARKETS ARE EXPOSED TO
MORE BUSINESS RISK COMPARE TO STABLE FIRMS.

Volatile markets are ones where the price moves vigorously and unpredictably.
 
INPUT COST VARIABILITY:
 
INPUT COSTS THAT ARE HIGHLY UNCERTAIN HAVE HIGHER DEGREE OF
BUSINESS RISK
 ABILITY TO ADJUST OUTPUT PRICES FOR CHANGES IN INPUT PRICES:
 
THE GREATER THE ABILITY TO ADJUST OUTPUT PRICES WHEN INPUT COST RISES
 
 FOREIGN RISK EXPOSURE:
 
IF EARNINGS ARE COMING FROM OVERSEAS THEN HIGHER THE BUSINESS RISK
 
 THE EXTEND TO WHICH COSTS ARE FIXED (OPERATING LEVERAGE):
 
IF COSTS ARE FIXED AND DEMAND FALLS, THEN BUSINESS RISK INCREASES. IF A
HIGH % OF TOTAL COST IS FIXED THEN FIRM IS SAID TO HAVE A HIGH DEGREE
OF OPERATING LEVERAGE.
OPERATING LEVERAGE

• THE EXTENT TO WHICH FIXED COSTS ARE USED IN A FIRM’S

OPERATIONS

• OTHER THINGS HELD CONSTANT , THE HIGHER THE FIRM’S FIXED

COSTS , THE HIGHER WOULD BE ITS BUSINESS RISK.

• IF MOST COSTS ARE FIXED, HENCE DO NOT DECLINE WHEN

DEMAND FALLS, THEN THE FIRM HAS HIGH OPERATING
LEVERAGE.

• HIGH FIXED COSTS =HIGHER OPERATING LEVERAGE

Effect of operating leverage

• More operating leverage leads to more business

risk, for then a small sales decline causes a big
profit decline.
$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales
BREAKEVEN POINT
 THE VOLUME OF SALES AT WHICH THE TOTAL COSTS EQUAL TOTAL
REVENUES, CAUSING OPERATING PROFITS (OR EBIT) TP EQUAL ZERO

 SALES=COSTS

 PQ=VQ+F

 Q(BE)=F/P-V
OPERATING LEVERAGE

• HOW DOES OPERATING LEVERAGE AFFECT A

PROJECT’S OR FIRM’S EXPECTED RATE OF RETURN ,
AND THE RISKINESS OF THE PROJECT OF THE FIRM?
OPERATING LEVERAGE

• OTHER THINGS HELD CONSTANT, USING MORE

OPERATING LEVERAGE RAISES THE EXPECTED RATE
OF RETURN , BUT ALSO INCREASES THE RISKINESS
OF THAT RETURN

• HIGH FIXED COSTS ARE GENERALLY ASSOCIATED

WITH HIGHLY AUTOMATED , CAPITAL INTENSIVE
FIRMS AND INDUSTRIES.
 PLAN A PLAN B
PRICE $2.00 $2.00
VARIABLE COST $1.50 $1.00
FIXED COST $20000 $60000
ASSETS $200000 $200000
TAX RATE 40% 40%

OPERATING COST=VERIABLE COST+FIXED COST

TAX RATE = 40%, SO NI= EBIT (1-TAX RATE) = EBIT (0.6)
ROE=NI/EQUITY. THE FIR HAS NO DEBTS SO, ASSETS=EQUITY=$200000

DEMAN PRO UNITS DOLLAR OPERATI EBIT NI ROE OPERATING EBIT NI ROE
D (1) B (2) SOLD (3) SALES $ NG COST $ (6) $ (7) % COST $ (10) $ (11) %
(4) $ (5) (8) $ (9) (12)
TERRIBL 0 0
E 0.05
POOR 0.2 40000 80000

NORMA 0.5 100000 200000

L
GOOD 0.2 160000 320000

WONDE 0.05 200000 400000

RFUL

EXPECTE
D
VALUE
STAND.
DEV
Financial Risk

• It is the additional risk that is placed on the common stock holder as

a result of the decision to finance with debt.
Example
• Suppose 10 people decide to make a corporation.
• 1) If firm is capitalized only with equity then each investor share equally
in the business risk.

• 2) However if the firm is capitalized with 50% debt and 50% equity, in
this case the 5 investors who put up their money as equity will have to
bear all the business risk because - to cover interest charges, stock
holders will have to make the shortfall/losses (if any occur). Hence
common stock holder will be twice as risky as it would have been had
the firm been financed only with equity.

• Thus the use of debt or ‘Financial Leverage’ concentrates the firm’s

business on its stock holders.
FINANCIAL LEVERAGE:

• THE EXTENT TO WHICH FIXED INCOME SECURITIES (DEBT)ARE USED IN

A FIRM’S CAPITAL STRUCTURE

WHY IS DEBT FINANCING RISKY:

 
 AS DEBT IS INTRODUCED IN THE COMPANY, ITS EPS AND RISK
CHANGES AND BOTH AFFECT THE COMPANY’S STOCK PRICE.
EXAMPLE: *
 

EBIT = 100,000
TAX RATE = 40%
EQUITY = 200,000
SHARES OUTSTANDING = 10,000
 
CASE#1: WHEN THERE IS NO DEBT FINANCING
 
EBIT=
- INTEREST PAYMENT =
EBT=
-TAX =
NI
 
ROE = NI / EQUITY

 
EPS = NI / # OF SHARES OUTSTANDING
EPS=(SALES-FIXED COST-VARIABLE COST-INT)(1-TAX RATE)/SHARE OUTSTANDING
EPS= (EBIT-INT)(1-TAX RATE)/SHARE OUTSTANDING)
CASE #2: WHEN DEBT FINANCING IS INTRODUCED
 
 EBIT = 100,000
 TAX RATE = 40%
 DEBT = 100000
 EQUITY = 100,000
 SHARES OUTSTANDING = 5,000
 INTEREST RATE = 12%

 NI
 
 ROE
 
 EPS
 FINDINGS
• FINANCING WITH DEBT INCREASES THE EXPECTED EPS BUT IT
ALSO INCREASES THE RISKINESS OF THE INVESTMENT TO THE
OWNERS AS INTEREST CHARGE INCREASES.

• RISK IS MEASURED BY STANDARD DEVIATION AND COEFFICIENT

OF VARIATION

• FINANCIAL LEVERAGE RAISES THE EXPECTED ROE (upto certain

level)
 RELATIOSHIP AMONG E(EPS), RISK
AND FINANCIAL LEVERAGE
DEBT/ASSET RATIO EXPECTED EPS S.D of EPS

0% $2.40 $2.96

10 2.56 3.29

20 2.75 3.70

30 2.97 4.23

40 3.20 4.94

50 3.36 5.93

60 3.30 7.41
*Optimal Capital Structure

• OPTIMAL CAPITAL STRUCTURE IS THE ONE,

WHICH MAXIMIZES THE COMPANY’S STOCK
PRICE .
• Trades off higher ROE and EPS against higher risk.

• The tax-related benefits of leverage are exactly

offset by the debt’s risk-related costs.

• Leverage works to increase the stock price .

However increase in risk level tends to decrease
the stock price. Hence higher EPS is offset by the
corresponding increase in risk
Stock Price, with zero growth

D1 EPS DPS
P0   
ks - g ks ks

• If all earnings are paid out as dividends, E(g) =

0.
• EPS = DPS
• To find the expected stock price (P0), we must
find the appropriate ks at each of the debt
levels discussed.
 Example
Debt Kd Expected Estimate K Estimate P/E ratio= WACC
Ratio EPS = dβ d Price P0 / EPS
DPS (P0) =
DPS / K

0 - $2.4 1.5 12% 20 8.33 12

10 8% 2.56 1.55 12.2 20.98 8.2 11.46

20 8.3 2.75 1.65 12.6 21.83 7.94 11.08

30 9 2.97 1.8 13.2 22.5 7.58 10.86

40 10 3.2 2 14 22.86 7.14 10.8

50 12 3.36 2.3 15.2 22.11 6.58 11.2

60 15 3.30 2.7 16.8 19.64 5.95 12.12

• The example shows that we can push up E(EPS) by using
more debt, but the risk resulting from increased leverage
more than offsets the benefit of higher E(EPS).
TIE ratio

• Times Interest Earned Ratio = (net income + interest) / interest.

• The times interest earned ratio indicates the extent of which

earnings are available to meet interest payments.

• A lower times interest earned ratio means less earnings are available

to meet interest payments and that the business is more vulnerable
to increases in interest rates. 
This is not it!

• INDUSTRY AVERAGE DEBT RATIO

• Discussion with- SEC,RATING AGENCIES

• LENDER’S ATTITUDE
Why do the bond rating and cost of debt
depend upon the amount borrowed?

• As the firm borrows more money, the firm increases its

financial risk causing the firm’s bond rating to decrease, and its
cost of debt to increase.
What makes companies to limit Debt Financing:
 
• BUSINESS RISK INCREASES
 
• FINANCIAL RISK INCREASES THAT CAUSES EPS AND SHARE PRICE TO
FALL.
 
• BANKRUPTCY COST IS ATTACHED WITH DEBT FINANCING.
 EFFECTS OF BANKRUPTCY COSTS
• BANKRUPTCY FORCES FIRMS TO LIQUIDATE OR SELL ASSETS FOR
LESS THAN THEY WOULD BE WORTH OF THE FIRM WERE TO
CONTINUE OPERATING

• THREAT OF BANKRUPTCY BRINGS ABOUT PROBLEMS AS WELL.E.G

SUPPLIERS REFUSE TO GRANT CREDIT , LENDERS DEMAND HIGHER
RATE OF INTERES ETC.

• BANKRUPTCY PROBLEMS ARE GOING TO ARISE WHEN THERE IS

MORE DEBT IN THE CAPITAL STRUCTURE
Capital Structure Theories

• Trade off theory-FIRMS NEED TO TRADE OFF BETWEEN BENEFITS OF

DEBT FINANCING AND HIGH INTEREST RATES AND BANKRUPTCY
COSTS.
• -Specifically, according to the tradeoff theory, the firm value can be
maximized by achieving the target capital structure which minimizes
taxes and agency costs.
• Pecking Order Theory- Based on the pecking order theory,
asymmetric information, higher costs and taxes are responsible for
the popularity of debt, but the internal fund/retained earnings
should be preferred to any external financing for the reason of
efficient control.
Modigliani-Miller theory (1958)

• Based on the assumptions of perfect market, absence of personal

taxes and independent financial activities, the Modigliani-Miller
(1958) theory indicates that the decision of capital structure is
irrelevant to firm value. However, in reality such assumptions are
untenable.
*Modigliani–Miller Theory (1958)

• The Modigliani–Miller (Franco Modigliani, Merton Miller) theory

states that, in an efficient market; in the absence of taxes,
bankruptcy costs, agency costs, and asymmetric information, the
value of a firm is unaffected by how that firm is financed. It does not
matter if the firm's capital is raised by issuing stock or selling debt. It
does not matter what the firm's dividend policy is. Therefore, the
Modigliani–Miller theorem is also often called the capital structure
irrelevance principle.
Assumptions of MM theory

(a) There are no taxes

(b) Managers have stockholder interests at hear and do what’s best for
stockholders.
(c) No firm ever goes bankrupt
(d) Firms know their future financing needs with certainty