Chapter One

Capital Structure Policy and Leverage

The most crucial component of starting a business is capital. It acts as the foundation of
the company. Debt and Equity are the two primary types of capital sources for a business.
Capital structure is defined as the combination of equity and debt that is put into use by a
company in order to finance the overall operations of the company and for its growth.

1.1 The capital structure question

It is a question of how should a firm go about choosing its debt/equity ratio. Is there an
optimum capital structure that maximizes firm’s value? Capital structure and cost of
capital relationships. The value of the firm is maximized when the WACC is minimized.
WACC is the discount rate that is appropriate for the firm’s overall cash flows and values
and discount rate move in opposite directions, minimizing the WACC will maximize the
value of the firm’s cash flows.
1.2. Factors that influence capital structure decisions
1. EBIT-EPS Analysis 5. Timing and flexibility
2. Cost of capital 6. Nature and Size of the Firm
3. Cash flow analysis 7. Industry Standard
4. Control
1. EBIT-EPS Analysis
It is needless to say that if we want to examine the effect of leverage, we are to analyze
the relationship between the EBIT (Earnings before interest and Tax) and EPS (earnings
per share). Practically, it requires the comparison of various alternative methods of
financing under various alternative assumptions relating to Earnings Before Interest and
Taxes.
Financial leverage or trading on equity arises when fixed assets are financed from debt
capital, (including preference shares). When the same gives a return which is greater than
the cost of debt capital, the excess will increase the EPS (Earnings per share) and the
same is also applicable in case of preference share capital.
2. Cost of Capital:

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While explaining cost of capital we have mentioned that usually cost of equity (Ke) is
greater than the cost of debt (Kd) due to the most significant advantages of income-tax
among others. Actually, financing decision should be based on overall cost of capital
(i.e., after considering both equity and debt). In other words, their combination will be in
such a way so that, either it minimizes the overall cost of capital or maximizes the market
value of the firm.
If debt financing is increased there will be a corresponding reduction in the overall cost
of capital till the rate of return exceeds the explicit cost of financing. But if debt financing
is continuously increased, the same will increase the cost of equity and debt capital as
well which invites more financial risk and consequently increases the weighted average
cost of capital up to a certain level of debt-equity mix. It can further be stated that if debt-
financing is continuously taken by a firm to minimize the overall cost of capital, the debt
after attaining a certain limit, will become costly as well as risky sources of finance.
Thus, if the degree of leverage increases, the creditors desires a high rate of interest for
increased risk and if the debt reaches at a particular point, they will not provide any loan
further Moreover, the position of the shareholders becomes risky due to such excessive
debt for which cost of equity is increased gradually. So, combination of debt and equity
will be in such a manner so that the market value per share increases and minimizes the
average cost of capital of a firm.
3. Cash Flow Analysis:
In order to meet the service fixed charge of a firm, analysis of cash flow is very important
it indicates the ability of the firm to meet its various commitments including the service
fixed charges which includes fixed operating charges and interest on debt capital. Thus,
the analysis of the cash flow ability of the firm to service fixed charges is no doubt an
important tool while analyzing financial risk in addition to EBIT-EPS analysis in capital
structure planning.
It has already been mentioned earlier that if the amount of debt capital increases, there is
a corresponding increase in the amount of uncertainty which a firm must have to face to
meet its obligation in the form of fixed charges. Because, if a firm borrows more than its
capacity and if it fails to meet its maturing, obligation at a future date, the creditors will

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acquire the assets of the firm for their unsatisfied claim which brings financial
insolvency.
If there is greater and stable expected future cash flow; a firm should go for a higher
degree of debt which can be used as a source of finance. Similarly, if the expected future
cash flows are unstable and smaller, a firm should avoid any fixed-charge securities
which will be considered a very risky proposition.
4. Control:
We know that the equity shareholders being the owner of the firm can exercise control
over the affairs of the firm. They have also the voting right. They do not have any voting
rights for the appointment of board of directors as well, other lenders and creditors also,
like debenture holders and preference shareholders, do not have any ‘say’ in the
management of the company. i.e., they cannot actually take part in the management as
the entire body is being controlled by the equity holders or the owners of the company.
the firm should select an appropriate debt-equity mix after considering its overall
profitability.
5. Timing and Flexibility:
After determining an appropriate capital structure, a firm has to face this problem relating
to timing of security issues. For procuring additional funds, a firm has to face the
question of appropriate mix of debt and equity and what should be the timing of issuing
such securities in order to maintain strict proportion of debt and equity, although it is not
an easy task. At the same time, which one will be issued at first i.e., whether debt at first
and equity at last or vice-versa, that also should be decided.
If the existing rate of interest on debt capital is high and there is the possibility of coming
down the rate of such interest, the management will go for issuing equity shares now and
will postpone debt issue. On the contrary, if the market for company’s equity issues are
depressed but that is chance is near future to improve for the same, naturally, the
management must go for debt issues now and will postpone the equity issues. The same
may be issued at a later date when there will be a favorable condition for the company,
i.e., the market for company’s equity shares will go up. It is needless to mention again
that if the alternative stated above, is chosen, a certain amount of flexibility must be
sacrificed. The trade-off is between preserving financial flexibility and dilution in

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earnings per share. If the price of the stock is high, however, and expected to fall, the
firm can achieve both the flexibility and minimum dilution by issuing stock now.
6. Nature and Size of the Firm
The nature and size of the firm have a significant role while procuring funds from various
sources. For example, it is very difficult for a small firm to raise funds from long term
sources even if its credit status is good. The same is available for it at a comparatively
high rate of interest with inconvenient repayment terms as well.
7. Industry Standard
Evaluation of capital structure of other similar risk-class firm is absolutely needed when
designing the capital structure of a firm and also the industrial position. Because if a firm
follows a different capital structure than that of the similar firm in the same industry, it
may have to face a lot of problems e.g., investors may not accept. It is needless to say that
lenders and creditors together with the investment analysts evaluate always the firm
according to the industry standard.
1.3 Business and Financial risk
Business risk is defined as the equity risk that comes from the nature of the firm’s
operating activities. Business risk depends on the systematic risk of the firm’s asset. The
greater a firm’s business risk, the greater RA will be, and, all other things the same, the
greater the will be its cost of equity. The basic risk inherent in the operations of a firm is
called business risk. Business risk can be viewed as the variability of a firm’s Earnings
Before Interest and Taxes (EBIT).
Financial Risk is the risk arising due to the use of debt financing in the capital structure.
Financial risk is a debt causes financial risk because it imposes a fixed cost in the form of
interest payments. It can be defined as the risk of not being able to pay off the debt.
There are two kinds of leverage in finance: operating leverage and financial leverage
Operating leverage
Operating leverage refers to magnifying gains and losses in earnings before interest and
taxes (EBIT) by changes that occur in sales. This magnification occurs because in
employing assets the firm incurs certain fixed costs, costs unrelated to the sales volume
created by the assets. Operating costs can be divided into variable and fixed costs. As
sales changes, variable costs change proportionally. This means the variable cost ratio to

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sales is constant. This is true over some relevant range of sales. Variable cost includes
material, direct labor, repair and maintenance expenses. In the long run all costs are
variable. Fixed costs include depreciation, indirect labor cost, overhead costs.
Degree of Operating Leverage (DOL)
Degree of operating leverage is computed as:

DOL= %ΔEBIT
%Output where, EBIT is earning before interest and tax
Or
=1+ F
EBIT where, F is fixed operating cost
Or
Example,
DOL at base sales level Q = Q(P-V)
P= 10 birr Q(P-V)-F where, Q is quantity, P is price,
V is variable cost and F is fixed cost
V= 4 birr
F= 30,000 birr
Level of output (Q) is 8,000 and increase to 10,000 units.
Required:
Determine DOL?
Solution:
EBIT= Q(P-V)-F
=8000(10-4)-30,000 = 18,000
EBIT= 10,000(10-4)-30,000=30,000
Percentage change in EBIT= (30,000-18,000)/18,000=66.67%
Percentage change in our puts = (10,000-8,000)/8,000=25%
DOL= %ΔEBIT 1+ 30,000/18,000=2.67
%Output or
66.67%/25%=2.67 = Q(P-V)
or Q(P-V)-F
1+ F =8,000(10-4)
EBIT 8,000(10-4)-30,000
=2.67
The coefficient of operating leverage of 2.67 is interpreted as a 1% change in output form
the current base levels, there will be a 2.67% change in EBIT in the same direction as the
output (sales) change. If output (sales) increase by 10%, EBIT will increase by 26.7%

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(10x 2.67%). Similarly, if output (sales) decrease by 10%, EBIT will decrease by 26.7%.
Other things equal, the higher the fixed costs relative to variable costs, the higher the
operating leverage.

Example,

A firm has a base level of 150,000 units of sales. The sales price per unit is $10.00 and
variable costs per unit are $6.50. Total annual operating fixed costs are $155,000, and the
annual interest expense is $90,000. What is this firm’s degree of operating leverage
(DOL)?

Solution

DOL = Q(P-V) = 150,000(10-6.50)

Q(P-V)-F 150,000(10-6.50)-150,000
=1.4
Financial risk and financial leverage
Financial Leverage
Operating leverage refers to the fact that a lower ratio of variable cost per unit to price
per unit causes profit to vary more with a change in the level of output than it would if
this ratio was higher. Financial leverage refers to the fact that a higher ratio of debt to
equity causes profitability to vary more when earnings on assets changes than it would if
this ratio was lower. Financial leverage is created by financing with sources of capital
that have fixed costs.
The major sources of fixed charges financing are debt (requiring interest payment) and
preferred stock require dividend payment and leases which require lease payments. These
financing fixed costs affect the firm’s earning per share (EPS) in the same way that
operating fixed costs affect EBIT. The more fixed charge financing the firm uses, the
more financial leverage it will have.
Degree of Financial leverage:
Degree of financial leverage is defined as the percentage change in EPS divided by the
percentage change in EBIT.

DFL = %Δ in EPS
%Δ in EBIT
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Where, EPS is earning per share
 EPS = (EBIT-I) (1-T)-D
N
Where, N is number of common stock outstanding shares.
Or
DFL = EBIT
EBIT-I-L-D/(1-T)
Where, I is interest payment
L is lease payment
D is dividend payment
T is tax rate

Unlike interest and lease payments, preferred dividends are not tax deductible. Therefore,
dividend payment has to be adjusted by dividing with (1-T) to make it on equivalent
basis.
Example,
A firm has a base level of 500,000 units of sales and increase to 600,000 units. The sales
price per unit is $10.00 and variable costs per unit are $6.50. Total annual operating fixed
costs are $1,250,000, and the annual interest expense is $100,000. The firm paid 80,000
for preferred stock holders and has 60,000 outstanding shares of common stock. The firm
tax rate is 40%.
1. What is the firm’ earning per share?
2. What is the firm’s degree of financial leverage (DFL)?
Solution:
1. EPS = (EBIT-I) (1-T)-D
N
EBIT = 500,000(10-6.50)-1,250,000=500,000
EPS = (500,000-100,000) (1-0.4)-80,000
60,000
=2.67
If sales increases from 500,000 to 600,000 units the resulting EBIT and EPS is:
EBIT = 600,000(10-6.50)-1,250,000 EPS=(850,000-100,000)(1-0.4) 80,000
=850,000 60,000

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 =6.16
DFL = %Δ in EPS or
%Δ in EBIT DFL = EBIT
EBIT-I-L-D/(1-T)
= (6.16-2.67)/2.67 = . 500,000 .
500,000-100,000- 80,000/ (1-0.4)
=1.307/0.7= 1.87 =1.87
(850,000-500,000)/500,000
The theory of capital structure
Major theories of Capital structure
1. Net income (NI) theory 3. Traditional theory
2. Net operating income (NPI) theory 4. Modigliani-Miller (M-M) Theory
5. Other views of capital structure like pecking order theory, trade-off theory…
Net Income (NI) theory
Net Income theory was introduced by David Durand.
 According to this approach, the capital structure decision is relevant to the
valuation of the firm. This means that a change in the financial leverage will
automatically lead to a corresponding change in the overall cost of capital as well
as the total value of the firm.
 According to NI approach, if the financial leverage increases, the weighted
average cost of capital decreases and the value of the firm and the market price of
the equity shares increases.
 Similarly, if the financial leverage decreases, the weighted average cost of capital
increases and the value of the firm and the market price of the equity shares
decreases.
Assumptions of NI Theory:
The ‘kd’ is cheaper than the ‘ke’.
It is due to the fact that debt is, generally a cheaper source of funds because:
(i) Interest rates are lower than dividend rates due to element of risk,
(ii) The benefit of tax as the interest is deductible expense for income tax purpose.
 There are no taxes

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  The risk perception of investors is not changed by the use of debt.
 The cost of debt capital(kd) and the cost of equity capital (ke) remain unchanged
when the degree of leverage (the proportion of debt and equity (D/S)) varies.
 The constancy of kd and ke with respect to D/S means that:
the average cost of capital or weighted average cost of capital (WACC) (kw),
measured as:
Kw = kd (D/ (D + S)) + ke (S/ (D +S)),
declines as D/S increases. This happens because when D/S increases, kd, which is
lower than ke receivers a higher weight in the calculation of kw.
Net operating income (NOI) theory
 This theory is also known as “Irrelevant Theory”, which was also suggested by
Durand
 According to this theory, the total market value of the firm (V) is not affected by
the change in the capital structure and the overall cost of capital (kw) remains
fixed irrespective of the debt-equity mix.
 This approach is of the opposite view of Net Income approach.
 This approach suggests that the capital structure decision of a firm is irrelevant
and that any change in the leverage or debt will not result in a change in the total
value of the firm as well as the market price of its shares.
 This approach also says that the overall cost of capital is independent of the
degree of leverage.
 According to the net operating income approach, the overall capitalisation rate
and the cost of debt remain constant for all degrees of leverage. In the equation
kw= kd (D/(D+S)) + k e (S/(D+S))
 kw and kd are constant for all degrees of leverage. Given this the cost of equity can
be expressed as:
ke = kw + (kw - kd) (D/S)
 The critical premise of this approach is that the market capitalizes the firm as a
whole at a discount rate, which is independent of the firm’s degree of leverage. As
a consequence, the division between debt and equity is irrelevant.
 An increase in the use of debt funds, which are apparently cheaper, is offset by an
increase in the equity capitalisation rate. This happens because equity investors

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 seek higher return as they are exposed to greater risk arising from increase in the
degree of leverage.
Exercise:
Assume that a firm has an EBIT level of Br. 25,000, the total value of debt Br. 100,000 at
10% interest(Kd)and the WACC is 12.5%.
Required:
Find out the total market value of the firm and the cost of equity capital (the equity
capitalization rate) in case of NOI approach.
Solution
 Total market value of the firm(V) = EBIT/Kw
= 25,000/0.125
= 200,000
Cost of equity capital(ke) = Earnings available to equity holders(E)/Total
market value of equity shares (S)
ke = E/S
E = EBIT – I Therefore, ke = E/S =
= 25,000 - (100,000 * 10%) 15,000/100,000 = 15% or
= 25,000 -10,000
= 15,000  ke = kw + (kw - kd) (D/S)
S = V- D = 200,000 – 100,000 = 12.5% +(12.5% - 10%) *
= 100,000 (100,000/100,000)
= 12.5% + 2.5%
= 15%
Traditional theory
 This theory was advocated by financial experts, Ezra Solomon and Fred Weston.
 Traditional Approach is the mix of Net Income approach and Net Operating
Income approach. Hence, it is also called as intermediate approach.
 According to the traditional approach, mix of debt and equity capital can increase
the value of the firm by reducing overall cost of capital up to certain level of debt.

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 Traditional approach states that the kw decreases only within the responsible limit
of financial leverage and when reaching the minimum level, it starts increasing
with financial leverage.
 According to this theory, a firm can reduce the overall cost of capital or increase
the total value of the firm by increasing the debt proportion in its capital structure
to a certain limit. Because debt is a cheap source of raising funds as compared to
equity capital.
The main propositions of the traditional approach are:
1. The cost of debt capital kd remains more or less constant up to a certain degree of
leverage but rises thereafter at an increasing rate.
2. The cost of equity capital, k e remain more or less constant or rises only gradually up to
a certain degree of leverage and rises sharply thereafter.
3. The average cost of capital, kw as a consequence of the above behaviour of ke and kd :
(i) Decrease up to a certain point;
(ii) Remains more or less unchanged for moderate increases in leverage thereafter; and
(iii) Rises beyond a certain point.
Stages in traditional theory:
First Stage: Increasing value
 The use of debt in capital structure increases the ‘V’ and decreases the ‘KW or
WACC’. Because ‘Ke’ remains constant or rises slightly with debt, but it does not
rise fast enough to offset the advantages of low cost debt. ‘Kd’ remains constant
or rises very negligibly.
Second stage: Optimum Value
 After certain degree of leverage, increase in leverage have a negligible effect on
WACC and hence on the value of the firm. During this Stage, there is a range in
which the ‘V’ will be maximum and the ‘Kw’ will be minimum. Because the
increase in the ‘Ke’, due to increase in financial risk, offset the advantage of using
low cost of debt. Optimal Capital Structure -- The capital structure that
minimizes the firm’s cost of capital and thereby maximizes the value of the firm.
Third stage – Declining Value

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  Beyond the acceptable limit of leverage, the value of the firm decreases with
leverage as WACC increases with leverage. As financial risk increases, exceeding
the advantage of low cost debt.
Browse and read the following theory.
 Modigliani and Miller (MM) theories of capital structure with tax and without tax
 Pecking order theory of capital structure
 Trade-off theory of capital structure

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