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Capital Structure

Capital Structure concept


Capital Structure planning
Concept of Value of a Firm
Significance of Cost of
Capital (WACC)
Capital Structure
Coverage
Capital Structure theories
Net Income
Net Operating Income
Modigliani-Miller
Traditional Approach
Capital structure can be defined as the mix of owned
capital (equity, reserves & surplus) and borrowed capital
(debentures, loans from banks, financial institutions)
Maximization of shareholders wealth is prime objective
of a financial manager. The same may be achieved if an
optimal capital structure is designed for the company.
Planning a capital structure is a highly psychological,
complex and qualitative process.
It involves balancing the shareholders expectations
(risk & returns) and capital requirements of the firm.
Capital Structure
Planning the Capital Structure
Important Considerations
Return: ability to generate maximum returns to the shareholders,
i.e. maximize EPS and market price per share.
Cost: minimizes the cost of capital (WACC). Debt is cheaper than
equity due to tax shield on interest & no benefit on dividends.
Risk: insolvency risk associated with high debt component.
Control: avoid dilution of management control, hence debt
preferred to new equity shares.
Flexible: altering capital structure without much costs & delays,
to raise funds whenever required.
Capacity: ability to generate profits to pay interest and principal.
Value of a firm depends upon earnings of a firm and its
cost of capital (i.e. WACC).
Earnings are a function of investment decisions, operating
efficiencies, & WACC is a function of its capital structure.
Value of firm is derived by capitalizing the earnings by its
cost of capital (WACC). Value of Firm = Earnings / WACC
Thus, value of a firm varies due to changes in the earnings
of a company or its cost of capital, or both.
Capital structure cannot affect the total earnings of a firm
(EBIT), but it can affect the residual shareholders earnings.
Value of a Firm directly co-related with
the maximization of shareholders wealth.
Particulars Rs.
Sales (A) 10,000
(-) Cost of goods sold (B) 4,000
Gross Profit (C = A - B) 6,000
(-) Operating expenses (D) 2,500
Operating Profit (EBIT) (E = C - D) 3,500
(-) Interest (F) 1,000
EBT (G = E - F) 2,500
(-) Tax @ 30% (H) 750
PAT (I = G - H) 1,750
(-) Preference Dividends (J) 750
Profit for Equity Shareholders (K = I - J) 1,000
No. of Equity Shares (L) 200
Earning per Share (EPS) (K/L) 5
An illustration of
Income Statement
Capital structure

The mix of debt and equity finance used
by a company.
- Optimal capital structure:
The capital structure that maximises the
value of a company.
Does the value of the net operating cash
flow stream depend on how it is divided
between payments to lenders and
shareholders?
Effects of Financial Leverage
- Business risk:
The variability of future net cash flows attributed to the
nature of the companys operations (the risk faced by
shareholders if the company is financed only by
equity).
- Financial risk:
The risk involved in using debt as a source of finance.
- Effects of financial leverage:
Expected rate of return on equity is increased.
Variability of returns to shareholders increases.
Increasing leverage involves a trade-off between risk
and return.
WACC
- Weighted Average Cost of Capital
Also called the hurdle rate



- D = Market Value of Debt
- E = Market Value of Equity
- V = D + E
Costs of Financing

- Cost of Debt
YTM is a good estimate

- Cost of Common Stock
Derived from current market data Beta
Cost has 2 factors
Business or Asset Risk
Financing or Leverage Risk (Leverage increases equity
risk)
Example WACC
- Equity Information
5,00,000 shares
Rs 80 per share
Beta = 1.15
Market risk prem. = 9%
Risk-free rate = 5%
- Tax rate = 40%
- Debt Information
Rs10,00,000
Coupon rate = 10%
YTM = 8%
20 years to maturity
Cost of equity?
k
E
= 0.05 + 1.15(0.09) = 0.1535 or 15.35%
Cost of debt?
k
D
= 0.08 or 8%
Example WACC
- Capital structure weights?
E = 5,00,000 shares (Rs 80/share) = Rs
4,00,00,000
D = Rs1,00,00,000
V = 4 + 1 = Rs 5,00,00,000
- What is the WACC?
WACC = k
E
(E/V) +k
D
(D/V)
= 0.1535(4/5) + 0.08(1/5)
= 0.1228+0.016
=0.1338 or 13.38%
Capital Restructuring
- Capital restructuring
Adjusting leverage without changing the firms
assets
Increase leverage
Issue debt and repurchase outstanding shares
Decrease leverage
Issue new shares and retire outstanding debt
- Choose capital structure to max stockholder wealth
Maximizing firm value
Minimizing the WACC
Ex: Effect of Leverage
Current Proposed
Assets Rs 50,00,000 Rs 50,00,000
Debt 0 25,00,000
Equity Rs 50,00,000 Rs 25,00,000
D/E 0 1
Share Face Value Rs10 Rs 10
# Shares 5,00,000 2,50,000
Int. Rate N/A 10%
EBIT Rs 650,000
- D = Rs 0
Interest = 0, Net Income = Rs 6,50,000
EPS = Rs6,50,000/5,00,000 = Rs1.30

- D = Rs25,00,000 (D/E = 1)
Interest = 2,50,000
Net Income = 4,00,000
EPS = 4,00,000/2,50,000 = Rs1.6
ASSUMPTIONS
Firms use only two sources of funds equity & debt.
No change in investment decisions of the firm, i.e. no change in total
assets.
100 % dividend payout ratio, i.e. no retained earnings.
Business risk of firm is not affected by the financing mix.
No corporate or personal taxation.
Investors expect future profitability of the firm.
Capital Structure Theories
Capital Structure Theories
A) Net Income Approach (NI)
Net Income approach proposes that there is a definite
relationship between capital structure and value of the firm.
The capital structure of a firm influences its cost of capital
(WACC), and thus directly affects the value of the firm.
NI approach assumptions
o NI approach assumes that a continuous increase in debt does
not affect the risk perception of investors.
o Cost of debt (K
d
) is less than cost of equity (K
e
) [i.e. K
d
< K
e
]
o Corporate income taxes do not exist.

Capital Structure Theories
A) Net Income Approach (NI)
As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Earnings
WACC
Earnings (EBIT) being constant and WACC is reduced, the
value of a firm will always increase.
Thus, as per NI approach, a firm will have maximum value
at a point where WACC is minimum, i.e. when the firm is
almost debt-financed.
Capital Structure Theories
A) Net Income Approach (NI)
ke
ko
kd
Debt
Cost
kd
ke, ko
As the proportion of
debt (K
d
) in capital
structure increases,
the WACC (K
o
)
reduces.
Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000. Ke = 10%
Debt = Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000
Kd = 6%
Capital Structure Theories
A) Net Income Approach (NI)
Net Income Approach (NI)
EBIT of a firm Rs. 200,000. Ke = 10%
Debt capital Rs. 500,000 Kd = 6% Debt = 700,000 Debt = 200,000
Particulars case 1 case 2 case 3
EBIT 2,00,000 2,00,000 2,00,000
(-) Interest 30,000 42,000 12,000
EBT 1,70,000 1,58,000 1,88,000
Ke 10% 10% 10%
Value of Equity 17,00,000 15,80,000 18,80,000
(EBT / Ke)
Value of Debt 5,00,000 7,00,000 2,00,000
Total Value of Firm 22,00,000 22,80,000 20,80,000
Capital Structure Theories
B) Net Operating Income (NOI)
Net Operating Income (NOI) approach is the exact opposite
of the Net Income (NI) approach.
As per NOI approach, value of a firm is not dependent upon
its capital structure.
Assumptions
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only.
o The cost of debt (K
d
) is constant.
o Corporate income taxes do not exist.
Capital Structure Theories
B) Net Operating Income (NOI)
NOI propositions (i.e. school of thought)
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (K
e
)

A higher cost of equity (K
e
) nullifies the advantages gained
due to cheaper cost of debt (K
d
)

In other words, the finance mix is irrelevant and does not
affect the value of the firm.
Capital Structure Theories
B) Net Operating Income (NOI)
Cost of capital (K
o
)
is constant.
As the proportion
of debt increases,
(K
e
) increases.
No effect on total
cost of capital (WACC)
ke
ko
kd
Debt
Cost
Calculate the value of firm and cost of equity for the following capital structure -
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)
Capital Structure Theories
B) Net Operating Income (NOI)
Net Operating Income (NOI)
Particulars Option I Option II Option III
EBIT 200,000 200,000 200,000
WACC (Ko) 10% 10% 10%
Value of the firm 2,000,000 2,000,000 2,000,000
Value of Debt @ 6 % 300,000 400,000 500,000
Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000
Interest @ 6 % 18,000 24,000 30,000
EBT (EBIT - interest) 182,000 176,000 170,000
Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%
Summary of NOI Approach
- Critical assumption is k
o
remains constant.
- An increase in cheaper debt funds is
exactly offset by an increase in the
required rate of return on equity.
- As long as k
D
is constant, k
E
is a linear
function of the debt-to-equity ratio.
- Thus, there is no one optimal capital
structure.
Capital Structure Theories
C) Traditional Approach
The NI approach and NOI approach hold extreme views on
the relationship between capital structure, cost of capital and
the value of a firm.
Traditional approach (intermediate approach) is a compromise
between these two extreme approaches.
Traditional approach confirms the existence of an optimal
capital structure; where WACC is minimum and value is the
firm is maximum.
As per this approach, a best possible mix of debt and equity
will maximize the value of the firm.
Capital Structure Theories
C) Traditional Approach
The approach works in 3 stages
1) Value of the firm increases with an increase in borrowings
(since K
d
< K
e
). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders
risk (financial risk) and hence K
e
increases. K
d
also rises due
to higher debt, WACC increases & value of firm decreases.
Capital Structure Theories
C) Traditional Approach
ke
ko
kd
Debt
Cost
Cost of capital (K
o
)
reduces initially.
At a point, it settles
But after this point,
(K
o
) increases, due
to increase in the
cost of equity. (K
e
)
EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to
the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.
For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC
Capital Structure Theories
C) Traditional Approach
Particulars Presently case I case II
Debt component - 300,000 500,000
Rate of interest 0% 10% 12%
EBIT 150,000 150,000 150,000
(-) Interest - 30,000 60,000
EBT 150,000 120,000 90,000
Cost of equity (Ke) 16% 17% 20%
Value of Equity (EBT / Ke) 937,500 705,882 450,000
Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000
WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%
Capital Structure Theories
C) Traditional Approach
Summary of the Traditional
Approach
- The cost of capital is dependent on the
capital structure of the firm.
Initially, low-cost debt is not rising and replaces
more expensive equity financing and k
o
declines.
Then, increasing financial leverage and the
associated increase in k
e
and k
i
more than offsets
the benefits of lower cost debt financing.
- Thus, there is one optimal capital structure
where k
o
is at its lowest point.
- This is also the point where the firms total
value will be the largest (discounting at k
o
).
Capital Structure Theories
D) Modigliani Miller Model (MM)
MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
Further, the MM model adds a behavioural justification in
favour of the NOI approach (personal leverage)
Assumptions
o Capital markets are perfect and investors are free to buy, sell,
& switch between securities. Securities are infinitely divisible.
o Investors can borrow without restrictions at par with the firms.
o Investors are rational & informed of risk-return of all securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention
Capital Structure Theories
D) Modigliani Miller Model (MM)
MM Model proposition
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of operating
income (i.e. EBIT) by the appropriate rate (i.e. WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
= Expected EBIT
Expected WACC
Capital Structure Theories
D) Modigliani Miller Model (MM)
MM Model proposition
o As per MM, identical firms (except capital structure) will
have the same level of earnings.
o As per MM approach, if market values of identical firms
are different, arbitrage process will take place.
o In this process, investors will switch their securities
between identical firms (from levered firms to un-levered
firms) and receive the same returns from both firms.
Market value
of debt (Rs65M)

Market value
of equity (Rs35M)

Total firm market
value (Rs100M)
Total Value Principle:
Modigliani and Miller
- M&M assume an absence of taxes and market
imperfections.
- Investors can substitute personal for corporate
financial leverage.
Market value
of debt (Rs35M)

Market value
of equity (Rs65M)

Total firm market
value (Rs100M)
u Total market value is not altered by the capital structure (the
total size of the pies are the same).
Arbitrage and Total Market
Value of the Firm
Arbitrage -- Finding two assets that are
essentially the same and buying the
cheaper and selling the more expensive.

Two firms that are alike in every respect
EXCEPT capital structure MUST have the same
market value.
Otherwise, arbitrage is possible.
Arbitrage Example
Consider two firms that are identical in every
respect EXCEPT:
Company NL -- no financial leverage
Company L -- Rs30,000 of 12% debt
Market value of debt for Company L equals its par
value
Required return on equity
-- Company NL is 15%
-- Company L is 16%
NOI for each firm is Rs10,000
Earnings available to = E = O I
common shareholders = Rs10,000 - Rs0
= Rs10,000
Market value = E / k
e

of equity = Rs10,000 / .15
= Rs66,667
Total market value = Rs66,667 + Rs0
= Rs66,667
Overall capitalization rate = 15%
Debt-to-equity ratio = 0
Arbitrage Example:
Company NL
Valuation of Company NL
See Notes
Arbitrage Example:
Company L
Earnings available to = E = O I
common shareholders = Rs10,000 -
Rs3,600 =
Rs6,400
Market value = E / k
e

of equity = Rs6,400 / .16
= Rs40,000
Total market value = Rs40,000 +
Rs30,000 = Rs70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = .75
Valuation of Company L
Completing an Arbitrage
Transaction
Assume you own 1% of the stock of
Company L (equity value = Rs400).
You should:
1. Sell the stock in Company L for Rs400.
2. Borrow Rs300 at 12% interest (equals 1% of debt for
Company L).
3. Buy 1% of the stock in Company NL for Rs666.67.
This leaves you with Rs33.33 for other investments
(Rs400 + Rs300 - Rs666.67).
Completing an Arbitrage
Transaction
Original return on investment in Company L
Rs400 x 16% = Rs64
Return on investment after the transaction
Rs666.67 x 16% = Rs100 return on Company NL
Rs300 x 12% = Rs36 interest paid
Rs64 net return (Rs100 - Rs36) AND Rs33.33 left over.
This reduces the required net investment to Rs366.67 to
earn Rs64.
Summary of the Arbitrage
Transaction
- The equity share price in Company NL rises
based on increased share demand.
- The equity share price in Company L falls
based on selling pressures.
- Arbitrage continues until total firm values are
identical for companies NL and L.
- Therefore, all capital structures are equally
as acceptable.
The investor uses personal rather than corporate
financial leverage.
Capital Structure Theories
D) Modigliani Miller Model (MM)
Levered Firm
Value of levered firm = Rs. 110,000
Equity Rs. 60,000 + Debt Rs. 50,000
K
d
= 6 % , EBIT = Rs. 10,000,
Investor holds 10 % share capital

Un-Levered Firm
Value of un-levered firm = Rs. 100,000 (all equity)
EBIT = Rs. 10,000 and investor holds 10 % share capital
Capital Structure Theories
D) Modigliani Miller Model (MM)
( ) ( )
( )
Return from Levered Firm:
10 110, 000 50 000 10% 60, 000 6 000
10% 10, 000 6% 50, 000 1, 000 300 700
Alternate Strategy:
1. Sell shares in : 10% 60,000 6,000
2. Borrow (personal leverage):
Investment % , ,
Return
L
= = =
= = = (

=
10% 50,000 5,000
3. Buy shares in : 10% 100,000 10,000
Return from Alternate Strategy:
10,000
10% 10,000 1,000
: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Ca
U
Investment
Return
Less
=
=
=
= =
= =
= =
sh available 11,000 10,000 1,000 = =
Example of the Effects of
Corporate Taxes
Consider two identical firms EXCEPT:
Company ND -- no debt, 16% required
return
Company D -- Rs5,000 of 12% debt
Corporate tax rate is 40% for each company
NOI for each firm is Rs10,000
The judicious use of financial leverage (i.e.,
debt) provides a favorable impact on a
companys total valuation.
Earnings available to = E = O - I
common shareholders = Rs2,000 - Rs0
= Rs2,000
Tax Rate (T) = 40%
Income available to = EACS (1 - T)
common shareholders = Rs2,000 (1 - .4)
= Rs1,200
Total income available to = EAT + I
all security holders = Rs1,200 + 0
= Rs1,200
Corporate Tax Example:
Company ND
Valuation of Company ND (Note: has no debt)
Earnings available to = E = O - I
common shareholders = Rs2,000 - Rs600
= Rs1,400
Tax Rate (T) = 40%
Income available to = EACS (1 - T)
common shareholders = Rs1,400 (1 - .4)
= Rs840
Total income available to = EAT + I
all security holders = Rs840 + Rs600
= Rs1,440*
Corporate Tax Example:
Company D
Valuation of Company D (Note: has some debt)
* Rs240 annual tax-shield benefit of debt (i.e., Rs1,440 - Rs1,200)
Tax-Shield Benefits
Tax Shield -- A tax-deductible expense. The expense
protects (shields) an equivalent amount of revenue from
being taxed by reducing taxable income.
Present value of
tax-shield benefits
of debt*
=
(r) (B) (t
c
)
r
= (B) (t
c
)
* Permanent debt, so treated as a perpetuity
** Alternatively, Rs240 annual tax shield / .12 = Rs2,000, where
Rs240=Rs600 Interest expense x .40 tax rate.
=
(Rs5,000) (.4) = Rs2,000**
Value of the Levered Firm
Value of unlevered firm = Rs1,200 / .16
(Company ND) = Rs7,500*
Value of levered firm = Rs7,500 + 2,000
(Company D) = Rs9,500
Value of Value of Present value of
levered = firm if + tax-shield benefits
firm unlevered of debt
* Assuming zero growth and 100% dividend payout
Summary of Corporate
Tax Effects
- The greater the financial leverage, the lower the
cost of capital of the firm.
- The adjusted M&M proposition suggests an
optimal strategy is to take on the maximum
amount of financial leverage.
- This implies a capital structure of almost 100%
debt! Yet, this is not consistent with actual
behavior.
The greater the amount of debt, the greater the tax-shield
benefits and the greater the value of the firm.
Other Tax Issues
- Corporate plus personal taxes
Personal taxes reduce the corporate tax
advantage associated with debt.
Only a small portion of the explanation why
corporate debt usage is not near 100%.
Uncertainty of tax-shield benefits
Uncertainty increases the possibility of bankruptcy
and liquidation, which reduces the value of the tax
shield.
Market Imperfections and
Incentive Issues
- Agency costs
- Debt and the incentive to manage efficiently
- Institutional restrictions
- Transaction costs
Bankruptcy costs

Required Rate of Return on
Equity with Bankruptcy
Financial Leverage (B / S)
R
f
R
e
q
u
i
r
e
d

R
a
t
e

o
f

R
e
t
u
r
n

o
n

E
q
u
i
t
y

(
k
e
)

k
e
with no leverage
k
e
without bankruptcy costs
k
e
with bankruptcy costs
Premium
for financial
risk
Premium
for business
risk
Risk-free
rate
Agency Costs
- Monitoring includes bonding of agents, auditing
financial statements, and explicitly restricting
management decisions or actions.
- Costs are borne by shareholders.
- Monitoring costs, like bankruptcy costs, tend to rise at
an increasing rate with financial leverage.
Agency Costs -- Costs associated with monitoring
management to ensure that it behaves in ways consistent
with the firms contractual agreements with creditors and
shareholders.
Bankruptcy Costs, Agency
Costs, and Taxes
Optimal Financial Leverage
Taxes, bankruptcy, and
agency costs combined
Net tax effect
Financial Leverage (B/S)
C
o
s
t

o
f

C
a
p
i
t
a
l

(
%
)

Minimum Cost
of Capital Point
Bankruptcy Costs, Agency
Costs, and Taxes
As financial leverage increases, tax-shield
benefits increase as do bankruptcy and
agency costs.
Value of levered firm
= Value of firm if unlevered
+ Present value of tax-shield benefits of debt
- Present value of bankruptcy and agency costs
Capital Structure Theory

- Capital Structure: How a firm finances its assets i.e., equity
(E) or debt (D)

- Modigliani-Miller Theorem (MMT): Uses a simple model of
valuation
No arbitrage i.e., equal rates of return for equal risks.
Risk-free debt

- Under certain assumptions (perfect markets, no taxes or
bankruptcy costs, no asymmetric information, etc.), the value
of the firm (V) is independent of how the firm is financed.
V = D + E
- That is, there is no optimal capital structure.

- If MMTs assumptions are violated, then capital
structure matters.

- Usual violations
- Traditional finance: bankruptcy costs, agency
problems, taxes, asymmetric information.
- Behavioral finance: inefficient markets,
managerial and investor behavior.

- Q: If MMT is violated, what is the optimal
capital structure?
Financial Choices
Trade-off Theory - Theory that capital structure is
based on a trade-off between tax savings and
distress costs of debt.

Pecking Order Theory - Theory stating that firms
prefer to issue debt rather than equity if internal
finance is insufficient.
Financial Distress and tax shield impact on
the value of debt, equity and firm
Debt/Total Assets
M
a
r
k
e
t

V
a
l
u
e

o
f

T
h
e

F
i
r
m

Value of
unlevered
firm
PV of interest
tax shields
Costs of
financial distress
Value of levered firm
Optimal amount
of debt
Maximum value of firm
- WACC now is more hump-shaped (similar to the
traditional view though for different reasons).
- The minimum WACC occurs where the stock price is
maximized.
- Thus, the same capital structure that maximizes
stock price also minimizes the WACC.
Pecking Order Theory
The announcement of a stock issue drives down the stock price
because investors believe managers are more likely to issue when
shares are overpriced.

Therefore firms prefer internal finance since funds can be raised
without sending adverse signals.

If external finance is required, firms issue debt first and equity as a
last resort.

The most profitable firms borrow less not because they have lower
target debt ratios but because they don't need external finance.

Pecking Order Theory
Some Implications:
Internal equity may be better than external
equity.
If external capital is required, debt is better.
(There is less room for difference in opinions
about what debt is worth).

Financial Signaling
- Informational Asymmetry is based on the idea
that insiders (managers) know something
about the firm that outsiders (security holders)
do not.
- Changing the capital structure to include more
debt conveys that the firms stock price is
undervalued.
- This is a valid signal because of the possibility
of bankruptcy.
A manager may use capital structure changes to convey
information about the profitability and risk of the firm.
Timing and Flexibility
2. Flexibility
A decision today impacts the options open to the firm for future
financing options thereby reducing flexibility.
Often referred to as unused debt capacity.
1. Timing
After appropriate capital structure is determined it is still difficult to
decide when to issue debt or equity and in what order.
Factors considered include the current and expected health of the
firm and market conditions.
Operating Leverage
One potential effect caused by the
presence of operating leverage is
that a change in the volume of sales
results in a more than proportional
change in operating profit (or loss).
Operating Leverage -- The use of fixed
operating costs by the firm.
Impact of Operating
Leverage on Profits
Firm F Firm V Firm 2F
Sales $10 $11 $19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
Operating Profit 1 2 2.5
FC/total costs .78 .22 .82
FC/sales .70 .18 .72
(in thousands)
Impact of Operating
Leverage on Profits
- Now, subject each firm to a 50%
increase in sales for next year.
- Which firm do you think will be more
sensitive to the change in sales (i.e.,
show the largest percentage change
in operating profit, EBIT)?
[ ] Firm F; [ ] Firm V; [ ] Firm 2F.
Impact of Operating
Leverage on Profits
Firm F Firm V Firm 2F
Sales $15 $16.5 $29.25
Operating Costs
Fixed 7 2 14
Variable 3 10.5 4.5
Operating Profit $ 5 $ 4 $10.75
Percentage Change in EBIT*
400% 100% 330%
(in thousands)
* (EBIT
t
- EBIT
t-1
) / EBIT
t-1
Impact of Operating
Leverage on Profits
- Firm F is the most sensitive firm -- for it, a 50%
increase in sales leads to a 400% increase in
EBIT.
- Our example reveals that it is a mistake to
assume that the firm with the largest absolute or
relative amount of fixed costs automatically
shows the most dramatic effects of operating
leverage.
- Later, we will come up with an easy way to spot
the firm that is most sensitive to the presence of
operating leverage.
Degree of Operating
Leverage (DOL)
DOL at Q
units of
output
(or sales)
Degree of Operating Leverage -- The percentage
change in a firms operating profit (EBIT)
resulting from a 1 percent change in output
(sales).
=
Percentage change in
operating profit (EBIT)
Percentage change in
output (or sales)
Computing the DOL
DOL
Q units
Calculating the DOL for a single product or a
single-product firm.
=
Q (P - V)
Q (P - V) - FC
=
Q
Q - Q
BE
Computing the DOL
DOL
S dollars of
sales
Calculating the DOL for a
multiproduct firm.
=
S - VC
S - VC - FC
=
EBIT + FC
EBIT
Break-Even Point
Example

Lisa Miller wants to determine the degree of
operating leverage at sales levels of 6,000 and
8,000 units. As we did earlier, we will assume
that:
Fixed costs are $100,000
Baskets are sold for $43.75 each
Variable costs are $18.75 per basket
Computing BWs DOL
DOL
6,000 units
Computation based on the previously calculated
break-even point of 4,000 units
=
6,000
6,000 - 4,000
=
=
3
DOL
8,000 units
8,000
8,000 - 4,000
=
2
Interpretation of the DOL
A 1% increase in sales above the 8,000 unit
level increases EBIT by 2% because of the
existing operating leverage of the firm.
=
DOL
8,000 units
8,000
8,000 - 4,000
=
2
Interpretation of the DOL
2,000 4,000 6,000 8,000
1
2
3
4
5
QUANTITY PRODUCED AND SOLD
0
-1
-2
-3
-4
-5
D
E
G
R
E
E

O
F

O
P
E
R
A
T
I
N
G

L
E
V
E
R
A
G
E

(
D
O
L
)

Q
BE
Interpretation of the DOL
DOL is a quantitative measure of the
sensitivity of a firms operating profit to a
change in the firms sales.
The closer that a firm operates to its break-even
point, the higher is the absolute value of its DOL.
When comparing firms, the firm with the highest
DOL is the firm that will be most sensitive to a
change in sales.
Key Conclusions to be Drawn from the previous
slide and our Discussion of DOL
DOL and Business Risk
DOL is only one component of business
risk and becomes active only in the
presence of sales and production cost
variability.
DOL magnifies the variability of operating
profits and, hence, business risk.
Business Risk -- The inherent uncertainty in the
physical operations of the firm. Its impact is
shown in the variability of the firms operating
income (EBIT).
Financial Leverage
Financial leverage is acquired by
choice.
Used as a means of increasing the
return to common shareholders.
Financial Leverage -- The use of fixed
financing costs by the firm. The British
expression is gearing.
EBIT-EPS Break-Even, or
Indifference, Analysis
Calculate EPS for a given level of EBIT at
a given financing structure.
EBIT-EPS Break-Even Analysis -- Analysis of the
effect of financing alternatives on earnings per
share. The break-even point is the EBIT level
where EPS is the same for two (or more)
alternatives.
(EBIT - I) (1 - t) - Pref. Div.
# of Common Shares
EPS =
EBIT-EPS Chart
- Current common equity shares = 50,000
- $1 million in new financing of either:
All C.S. sold at $20/share (50,000 shares)
All debt with a coupon rate of 10%
All P.S. with a dividend rate of 9%
- Expected EBIT = $500,000
- Income tax rate is 30%
Basket Wonders has $2 million in LT financing
(100% common stock equity).
EBIT-EPS Calculation with
New Equity Financing
EBIT $500,000 $150,000*
Interest 0 0
EBT $500,000 $150,000
Taxes (30% x EBT) 150,000 45,000
EAT $350,000 $105,000
Preferred Dividends 0 0
EACS $350,000 $105,000
# of Shares 100,000 100,000
EPS $3.50 $1.05
Common Stock Equity Alternative
* A second analysis using $150,000 EBIT rather than the expected EBIT.
EBIT-EPS Chart
0 100 200 300 400 500 600 700
EBIT ($ thousands)
E
a
r
n
i
n
g
s

p
e
r

S
h
a
r
e

(
$
)

0
1
2
3
4
5
6
Common
EBIT-EPS Calculation with
New Debt Financing
EBIT $500,000 $150,000*
Interest 100,000 100,000
EBT $400,000 $ 50,000
Taxes (30% x EBT) 120,000 15,000
EAT $280,000 $ 35,000
Preferred Dividends 0 0
EACS $280,000 $ 35,000
# of Shares 50,000 50,000
EPS $5.60 $0.70
Long-term Debt Alternative
* A second analysis using $150,000 EBIT rather than the expected EBIT.
EBIT-EPS Chart
0 100 200 300 400 500 600 700
EBIT ($ thousands)
E
a
r
n
i
n
g
s

p
e
r

S
h
a
r
e

(
$
)

0
1
2
3
4
5
6
Common
Debt
Indifference point
between debt and
common stock
financing
EBIT-EPS Calculation with
New Preferred Financing
EBIT $500,000 $150,000*
Interest 0 0
EBT $500,000 $150,000
Taxes (30% x EBT) 150,000 45,000
EAT $350,000 $105,000
Preferred Dividends 90,000 90,000
EACS $260,000 $ 15,000
# of Shares 50,000 50,000
EPS $5.20 $0.30
Preferred Stock Alternative
* A second analysis using $150,000 EBIT rather than the expected EBIT.
0 100 200 300 400 500 600 700
EBIT-EPS Chart
EBIT ($ thousands)
E
a
r
n
i
n
g
s

p
e
r

S
h
a
r
e

(
$
)

0
1
2
3
4
5
6
Common
Debt
Indifference point
between preferred
stock and common
stock financing
Preferred
What About Risk?
0 100 200 300 400 500 600 700
EBIT ($ thousands)
E
a
r
n
i
n
g
s

p
e
r

S
h
a
r
e

(
$
)

0
1
2
3
4
5
6
Common
Debt
Lower risk. Only a small
probability that EPS will
be less if the debt
alternative is chosen.
P
r
o
b
a
b
i
l
i
t
y

o
f

O
c
c
u
r
r
e
n
c
e

(
f
o
r

t
h
e

p
r
o
b
a
b
i
l
i
t
y

d
i
s
t
r
i
b
u
t
i
o
n
)

What About Risk?
0 100 200 300 400 500 600 700
EBIT ($ thousands)
E
a
r
n
i
n
g
s

p
e
r

S
h
a
r
e

(
$
)

0
1
2
3
4
5
6
Common
Debt
Higher risk. A much larger
probability that EPS will
be less if the debt
alternative is chosen.
P
r
o
b
a
b
i
l
i
t
y

o
f

O
c
c
u
r
r
e
n
c
e

(
f
o
r

t
h
e

p
r
o
b
a
b
i
l
i
t
y

d
i
s
t
r
i
b
u
t
i
o
n
)

Degree of Financial Leverage
(DFL)
DFL at
EBIT of
X
dollars
Degree of Financial Leverage -- The percentage
change in a firms earnings per share (EPS)
resulting from a 1 percent change in operating
profit.
=
Percentage change in
earnings per share (EPS)
Percentage change in
operating profit (EBIT)
Computing the DFL
DFL
EBIT of $X
Calculating the DFL
=
EBIT
EBIT - I - [ PD / (1 - t) ]
EBIT = Earnings before interest and taxes
I = Interest
PD = Preferred dividends
t = Corporate tax rate
What is the DFL for Each
of the Financing Choices?
DFL
$500,000
Calculating the DFL for NEW equity* alternative
=
$500,000
$500,000 - 0 - [0 / (1 - 0)]
* The calculation is based on the expected EBIT
=
1.00
What is the DFL for Each
of the Financing Choices?
DFL
$500,000
Calculating the DFL for NEW debt * alternative
=
$500,000
{ $500,000 - 100,000
- [0 / (1 - 0)] }
* The calculation is based on the expected EBIT
=
$500,000 / $400,000
1.25
=
What is the DFL for Each
of the Financing Choices?
DFL
$500,000
Calculating the DFL for NEW preferred * alternative
=
$500,000
{ $500,000 - 0
- [90,000 / (1 - .30)] }
* The calculation is based on the expected EBIT
=
$500,000 / $400,000
1.35
=
Variability of EPS
Preferred stock financing will lead to
the greatest variability in earnings per
share based on the DFL.
This is due to the tax deductibility of
interest on debt financing.
DFL
Equity
= 1.00
DFL
Debt
= 1.25
DFL
Preferred
= 1.35
Which financing
method will have the
greatest relative
variability in EPS?
Financial Risk
Debt increases the probability of cash
insolvency over an all-equity-financed firm.
For example, our example firm must have EBIT
of at least $100,000 to cover the interest
payment.
Debt also increased the variability in EPS as
the DFL increased from 1.00 to 1.25.
Financial Risk -- The added variability in earnings per
share (EPS) -- plus the risk of possible insolvency -- that
is induced by the use of financial leverage.
Total Firm Risk
CV
EPS
is a measure of relative total firm risk
CV
EBIT
is a measure of relative business risk
The difference, CV
EPS
- CV
EBIT
, is a measure
of relative financial risk
Total Firm Risk -- The variability in earnings per share
(EPS). It is the sum of business plus financial risk.
Total firm risk = business risk + financial risk
Degree of Total Leverage
(DTL)
DTL at Q units
(or S dollars)
of output (or
sales)
Degree of Total Leverage -- The percentage
change in a firms earnings per share (EPS)
resulting from a 1 percent change in output
(sales).
=
Percentage change in
earnings per share (EPS)
Percentage change in
output (or sales)
Computing the DTL
DTL
S
dollars
of sales

DTL
Q units (or S dollars)
= ( DOL
Q units (or S dollars)
)
x ( DFL
EBIT of X dollars
)
=
EBIT + FC
EBIT - I - [ PD / (1 - t) ]
DTL
Q units
Q (P - V)
Q (P - V) - FC - I - [ PD / (1 - t) ]
=
DTL Example

Lisa Miller wants to determine the Degree of
Total Leverage at EBIT=$500,000. As we did
earlier, we will assume that:
Fixed costs are $100,000
Baskets are sold for $43.75 each
Variable costs are $18.75 per basket
Computing the DTL
for All-Equity Financing
DTL
S
dollars
of sales

=
$500,000 + $100,000
$500,000 - 0 - [ 0 / (1 - .3) ]
DTL
S dollars
= (DOL
S dollars
) x (DFL
EBIT of $S
)
DTL
S dollars
= (1.2 ) x ( 1.0* ) = 1.20
=
1.20
*Note: No financial leverage.
Computing the DTL
for Debt Financing
DTL
S
dollars
of sales

=
$500,000 + $100,000
{ $500,000 - $100,000
- [ 0 / (1 - .3) ] }
DTL
S dollars
= (DOL
S dollars
) x (DFL
EBIT of $S
)
DTL
S dollars
= (1.2 ) x ( 1.25* ) = 1.50
=
1.50
*Note: Calculated on Slide 16-44.
Risk versus Return
Compare the expected EPS to the DTL for the
common stock equity financing approach to the
debt financing approach.
Financing E(EPS) DTL
Equity $3.50 1.20
Debt $5.60 1.50
Greater expected return (higher EPS) comes at the expense
of greater potential risk (higher DTL)!
What is an Appropriate
Amount of Financial Leverage?
Firms must first analyze their expected future
cash flows.
The greater and more stable the expected future
cash flows, the greater the debt capacity.
Fixed charges include: debt principal and
interest payments, lease payments, and
preferred stock dividends.
Debt Capacity -- The maximum amount of debt (and
other fixed-charge financing) that a firm can adequately
service.
Coverage Ratios
Interest Coverage

EBIT
Interest expenses
Indicates a firms
ability to cover interest
charges.
Income Statement
Ratios
Coverage Ratios
A ratio value equal to 1
indicates that earnings
are just sufficient to
cover interest charges.
Coverage Ratios
Debt-service Coverage

EBIT
{ Interest expenses + [Principal
payments / (1-t) ] }
Indicates a firms ability
to cover interest
expenses and principal
payments.
Income Statement
Ratios
Coverage Ratios
Allows us to examine the
ability of the firm to meet
all of its debt payments.
Failure to make principal
payments is also default.
Coverage Example
Make an examination of the coverage ratios
for Basket Wonders when EBIT=$500,000.
Compare the equity and the debt financing
alternatives.
Assume that:
Interest expenses remain at $100,000
Principal payments of $100,000 are made
yearly for 10 years
Coverage Example
Compare the interest coverage and debt burden
ratios for equity and debt financing.
Interest Debt-service
Financing Coverage Coverage
Equity Infinite Infinite
Debt 5.00 2.50
The firm actually has greater risk than the interest coverage
ratio initially suggests.
Coverage Example
-250 0 250 500 750 1,000 1,250
EBIT ($ thousands)
Firm B has a much
smaller probability
of failing to meet its
obligations than Firm A.
Firm B
Firm A
Debt-service burden
= $200,000
P
R
O
B
A
B
I
L
I
T
Y

O
F

O
C
C
U
R
R
E
N
C
E

Summary of the Coverage Ratio
Discussion
- A single ratio value cannot be interpreted
identically for all firms as some firms have
greater debt capacity.
- Annual financial lease payments should be
added to both the numerator and
denominator of the debt-service coverage
ratio as financial leases are similar to debt.
The debt-service coverage ratio accounts for
required annual principal payments.
Other Methods of Analysis
Often, firms are compared to peer institutions in the
same industry.
Large deviations from norms must be justified.
For example, an industrys median debt-to-net-worth
ratio might be used as a benchmark for financial
leverage comparisons.
Capital Structure -- The mix (or proportion) of a firms
permanent long-term financing represented by debt,
preferred stock, and common stock equity.
Other Methods of Analysis
- Firms may gain insight into the
financial markets evaluation of their
firm by talking with:
Investment bankers
Institutional investors
Investment analysts
Lenders
Surveying Investment Analysts and Lenders
Other Methods of Analysis
- Firms must consider the impact of any
financing decision on the firms security
rating(s).
Security Ratings
Checklist of Practical and
Conceptual Considerations
1. Taxes
2. Explicit cost
3. Cash-flow ability to
service debt
4. Agency costs and
incentive issues
5. Financial signaling
6. EBIT-EPS
analysis
7. Capital structure
ratios
8. Security rating
9. Timing
10. Flexibility