Unit 3

Financing Decision: Financial Structure- Capital Structure Theories–NI, NOI Theory,

The Modigliani Miller Theory, and Traditional Theory –Concept and financial effects of
leverage - Operating Leverage, Financial Leverage, and Composite Leverage. EBIT – EPS
Analysis. hammaIndifference Point/Break even analysis of financial leverage.

Capital structure is the mix of long-term sources of funds like debentures, loans, preference shares,
equity shares and retained earnings in different ratios.

It is always advisable for companies to plan their capital structure. Decisions taken by not assessing
things in a correct manner may jeopardise the very existence of the company. Firms may prosper in
the short-run by not indulging in proper planning but ultimately may face problems in future. With
unplanned capital structure, they may also fail to economise the use of their funds and adapt to the
changing conditions.
Design of an Ideal Capital Structure
The design of an ideal capital structure requires five factors to be considered

• Return: The capital structure of a company should be most advantageous. It should

generate maximum returns to the shareholders for a considerable period of time and such
returns should keep increasing.
• Risk: Debt does increase equity holders‘ returns and this can be done till such time that no
risk is involved. Use of excessive debt funds may threaten the company‘s survival.
• Flexibility: The company should be able to adapt itself to situations warranting
changed circumstances with minimum cost and delay.
• Capacity: The capital structure of the company should be within the debt capacity. Debt
capacity depends on the ability for funds to be generated. Revenues earned should be
sufficient enough to pay creditors‘ interests, principal and also to shareholders to some
extent.

• Control: An ideal capital structure should involve minimum risk of loss of control to the
company. Dilution of control by indulging in excessive debt financing is undesirable.
With the above points on ideal capital structure, raising funds at the appropriate time to finance
firm‘s investment activities is an important activity of the Finance Manager. Golden
opportunities may be lost for delaying decisions to this effect.
A combination of debt and equity is used to fund the activities. What should be the proportion of

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 debt and equity? This depends on the costs associated with raising various sources of funds.

The cost of capital is the minimum rate of return of a company, which must earn to meet the
expenses of the various categories of investors who have made investment in the form of
loans, debentures and equity and preference shares.

A company now being able to meet these demands may face the risk of investors taking back
their investments thus leading to bankruptcy.

Loans and debentures come with a pre-determined interest rate. Preference shares also have a
fixed rate of dividend while equity holders expect a minimum return of dividend, based on their
risk perception and the company‘s past performance in terms of pay-out dividends.

The following graph on risk-return relationship of various securities summarises the above
discussion.

Equity
share
Required rate of return

Preference
share

Debt

Govt bonds

Risk free
security

Risk-Return relationship of various securities

Risk return relationship

Cost of Different Sources of Finance

The various sources of finance and their costs are explained in this section.
Cost of debentures
The cost of debenture is the discount rate which equates the net proceeds from issue of
debentures to the expected cash outflows.

The expected cash outflows relate to the interest and principal repayments.

I(1 − T ) + (F − P ) / n 
Kd =
(F + P ) / 2

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 Where Kd is post tax cost of debenture capital,
I is the annual interest payment per unit of debenture, T is
the corporate tax rate,
F is the redemption price per debenture,
P is the net amount realised per debenture, n is maturity period.

Cost of Term Loans

Term loans are loans taken from banks or financial institutions for a specified
number of years at a pre-determined interest rate. The cost of term loans is equal to the
interest rate multiplied by 1-tax rate. The interest is multiplied by 1-tax rate as interest on
term loans is also taxed.

Kt = I (1—T)
Where I is interest, T is tax rate

Cost of Preference Capital

The cost of preference share Kp is the discount rate which equates the proceeds from
preference capital issue to the dividend and principal repayments. It is expressed as:

Kp = (D + {(F – P) / n} / ((F + P) / 2)
Where Kp is the cost of preference capital,
D is the preference dividend per share payable, F is the redemption price,
P is the net proceeds per share,
n is the maturity period.

Cost of Equity Capital

Equity shareholders do not have a fixed rate of return on their investment. There is no
legal requirement (unlike in the case of loans or debentures where the rates are governed
by the deed) to pay regular dividends to them.

Measuring the rate of return to equity holders is a difficult and complex exercise.

There are many approaches for estimating return – the dividend forecast approach, capital
asset pricing approach, realised yield approach etc. According to dividend forecast
approach, the intrinsic value of an equity share is the sum of present values of dividends
associated with it.
Ke = (D1/Pe) + g

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This equation is modified from the equation, Pe= {D1/Ke-g}.
Dividends cannot be accurately forecasted as they may sometimes be nil or have a
constant growth or sometime have supernormal growth periods.

Is Equity Capital free of cost?

Some people are of the opinion that equity capital is free of cost as a company is
not legally bound to pay dividends and also as the rate of equity dividend is not fixed like
preference dividends. This is not a correct view as equity shareholders buy shares with the
expectation of dividends and capital appreciation. Dividends enhance the market value of
shares and therefore equity capital is not free of cost.

Cost of Retained Earnings

A company‘s earnings can be reinvested in full to fuel the ever-increasing demand of
company‘s fund requirements or they may be paid off to equity holders in full or they may be
partly held back and invested and partly paid off. These decisions are taken keeping in mind
the company‘s growth stages.
High growth companies may reinvest the entire earnings to grow more, companies with no
growth opportunities return the funds earned to their owners and companies with
constant growth invest a little and return the rest. Shareholders of companies with
high growth prospects utilising funds for reinvestment activities have to be compensated
for parting with their earnings.

Therefore the cost of retained earnings is the same as the cost of shareholders‘ expected
return from the firm‘s ordinary shares. So, Kr = Ke

Capital Asset Pricing Model Approach

This model establishes a relationship between the required rate of return of a security
and its systematic risks expressed as ―β‖. According to this model,

Ke = Rf + β (Rm — Rf)
Where Ke is the rate of return on share, Rf
is the risk free rate of return,
β is the beta of security,
Rm is return on market portfolio
The CAPM model is based on some assumptions, some of which are:
• Investors are risk-averse.
• Investors make their investment decisions on a single-period horizon.
• Transaction costs are low and therefore can be ignored. This translates to assets being

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 bought and sold in any quantity desired. The only considerations that matter are the price
and amount of money at the investor‘s disposal.
• All investors agree on the nature of return and risk associated with each investment.
Earnings Price Ratio Approach
Under the case of earnings price ratio approach, the cost of equity can be calculated as:
Ke = E1/P
Where E1 = expected EPS per one year
P = current market price per share
E1 is calculated by multiplying the present EPS with (1 + Growth rate).

Cost of Retained Earnings and Cost of External Equity

As we have just learnt that if retained earnings are reinvested in business for growth activities,
the shareholders expect the same amount of returns and therefore
Ke=Kr
However, it should be borne in mind by the policy makers that floating of a new issue and
people subscribing to the new issue will involve huge amounts of money towards floating
costs which need not be incurred if retained earnings are utilised towards funding activities. From
the dividend capitalisation model, the following model can be used for calculating cost of external
equity.
Ke = {D1/P0(1—f)} + g
Where, Ke is the cost of external equity,
D1 is the dividend expected at the end of year 1, P0 is the current market price per share,
g is the constant growth rate of dividends,
f is the floatation costs as a % of current market price

The following formula can be used as an approximation:

K‘e = Ke/(1—f)
Where K‘e is the cost of external equity,
Ke is the rate of return required by equity holders, f is the floatation cost.

Key Point

Dividends cannot be accurately forecasted as they might sometimes become nil or

have a constant growth or sometimes have supernormal growth periods.

Weighted Average Cost of Capital

In the previous section, we have calculated the cost of each component in the overall capital of

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the company. The term cost of capital refers to the overall composite cost of capital or the
weighted average cost of each specific type of fund. The purpose of using weighted average is
to consider each component in proportion of their contribution to the total fund available.
Use of weighted average is preferable to simple average method for the reason that firms do not
procure funds equally from various sources and therefore simple average method is not used. The
following steps are involved to calculate the WACC

Step I: Calculate the cost of each specific source of fund, that of debt, equity, preference
capital and term loans.
Step II: Determine the weights associated with each source.
Step III: Multiply the cost of each source by the appropriate weights.
Step IV: WACC = W e Ke + W r Kr + W p Kp + W d Kd + W t Kt

Assignment of weights
Weights can be assigned based on any of the following methods
• The book value of the sources of the funds in capital structure
• Present market value of funds in the capital structure and
• Adoption of finance planned for capital budget for the next period
As per the book value approach, weights assigned would be equal to each source‘s proportion in
the overall funds. The book value method is preferable. The market value approach uses the
market values of each source and the disadvantage in this method is that these values
change very frequently.

Leverage
A company uses different sources of financing to fund its activities. These sources can be
classified as those which carry a fixed rate of return and those whose returns vary. The fixed
sources of finance have a bearing on the return on shareholders. Borrowing funds as loans have
an impact on the return on shareholders and this is greatly affected by the magnitude of
borrowing in the capital structure of a firm.

Leverage is the influence of power to achieve something. The use of an asset or source of
funds for which the company has to pay a fixed cost or fixed return is termed as leverage.
Leverage is the influence of an independent financial variable on a dependent variable. It studies
how the dependent variable responds to a particular change in independent variable.

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There are three types of leverage as shown in the following diagram 6.1 –
operating, financial and combined.

Figure 6.1: Types of leverage

Operating leverage is associated with the asset purchase activities, while financial leverage is
associated with the financial activities. However, combined leverage is the combination of
operating leverage and the financial leverage.

Operating Leverage
Operating leverage arises due to the presence of fixed operating expenses in the firm’s income
flows. A company’s operating costs can be categorised into three main sections as shown in
figure 6.2 – fixed costs, variable costs
and semi-variable costs.

Fixed costs: Fixed costs are those which do not vary with an increase in production or sales
activities for a particular period of time. These are incurred irrespective of the income and value
of sales and generally cannot be reduced.

For example, consider that a firm named XYZ enterprises is planning to start a new business. The
main aspects that the firm should concentrate at are salaries to the employees, rents, insurance
of the firm and the accountancy costs. All these aspects relate to or are referred to as ―fixed
costs‖.

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• Variable costs
Variable costs are those which vary in direct proportion to output and sales. An increase or
decrease in production or sales activities will have a direct effect on such types of costs incurred.

For example, we have discussed about fixed costs in the above context. Now, the firm has to
concentrate on some other features like cost of labour, amount of raw material and the
administrative expenses. All these features relate to or are referred to as ―Variable costs‖, as
these costs are not fixed and keep changing depending upon the conditions.

• Semi-variable costs
Semi-variable costs are those which are partly fixed and partly variable in nature. These costs
are typically of fixed nature up to a certain level beyond which they vary with the firm’s activities.

For example, after considering both the fixed costs and the variable costs, the firm should
concentrate on some-other features like production cost and the wages paid to the workers
which act at some point of time as fixed costs and can also shift to variable costs. These
features relate to or are referred to as ―Semi-variable costs‖.

The operating leverage is the firm’s ability to use fixed operating costs to increase the effects of
changes in sales on its earnings before interest and taxes (EBIT). Operating leverage occurs any
time a firm has fixed costs. The percentage change in profits with a change in volume of sales is
more than the percentage change in volume.
Another way of explaining this phenomenon is examining the effect of the degree of operating
leverage (DOL). The DOL is a more precise measurement. It examines the effect of the change in
the quantity produced on earnings before interest and taxes (EBIT).

As operating leverage can be favourable or unfavourable, high risks are attached to higher
degrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses
increases the operating risks of the company and hence a higher degree of operating
leverage. Higher operating risks can be taken when income levels of companies are rising and
should not be ventured into when revenues move southwards.

Application of Operating Leverage

The applications of operating leverage are as follows:
• Business risk measurement
• Production planning
Measurement of business risk
Risk refers to the uncertain conditions in which a company performs. A business risk is measured

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using the degree of operating leverage (DOL) and the formula of DOL is:
DOL = {Q(S–V)} / {Q(S–V)–F}
Greater the DOL, more sensitive is the earnings before interest and tax (EBIT) to a given change in
unit sales. A high DOL is a measure of high business risk and vice versa.
Production planning
A change in production method increases or decreases DOL. A firm can change its cost structure
by mechanising its operations, thereby reducing its variable costs and increasing its fixed costs.
This will have a positive impact on DOL. This situation can be justified only if the company is
confident of achieving a higher amount of sales thereby increasing its earnings.

Financial Leverage
Financial leverage as opposed to operating leverage relates to the financing activities of a firm
and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of
the company.
A company’s sources of funds fall under two categories –
• Those which carry a fixed financial charges like debentures, bonds and preference shares and
• Those which do not carry any fixed charges like equity shares
Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the
firm’s revenues. Though dividends are not contractual obligations, dividend on preference shares
is a fixed charge and should be paid off before equity shareholders are paid any. The equity
holders are entitled to only the residual income of the firm after all prior obligations are met.

Financial leverage refers to the mix of debt and equity in the capital structure of the firm.
This results from the presence of fixed financial charges in the company’s income stream.
Such expenses have nothing to do with the firm’s performance and earnings and should be paid
off regardless of the amount of earnings before income and tax (EBIT).

It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on
the EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders.

A company earning more by the use of assets funded by fixed sources is said to be having a
favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning
sufficiently to cover the cost of funds. Financial leverage is also referred to as “Trading on Equity”.

This example shows that the presence of fixed interest source funds leads to a value more than
that occurs due to proportional change in EPS. The presence of such fixed sources implies the

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presence of financial leverage. This can be expressed in a different way. The degree of financial
leverage (DFL) is a more precise measurement. It examines the effect of the fixed
sources of funds on EPS.
DFL=%change in EPS
%change in EBIT

DFL={ΔEPS/EPS} ÷ {ΔEBIT/EBIT}
Or DFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}}
I is Interest, Dp is dividend on preference shares, T is tax rate.

Use of Financial Leverage

Studying the degree of financial leverage (DFL) at various levels makes financial decision-making,
on the use of fixed sources of funds, for funding activities easy. One can assess the impact of
change in earnings before interest and tax (EBIT) on earnings per share (EPS).
Like operating leverage, the risks are high at high degrees of financial leverage (DFL). High
financial costs are associated with high DFL. An increase in financial costs implies higher level
of EBIT to meet the necessary financial commitments.

A firm which is not capable of honouring its financial commitments may be forced to go into
liquidation by the lenders of funds. The existence of the firm is shaky under these
circumstances.
On one side the trading on equity improves considerably by the use of borrowed funds and on the
other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All
these factors should be considered while formulating the firm’s mix of sources of funds.

One main goal of financial planning is to devise a capital structure in order to provide a high
return to equity holders. But at the same time, this should not be done with heavy debt financing
which drives the company on to the brink of winding up.
Impact of financial leverage
Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend
them further to fuel their expansion activities. On being forced to continue lending, they may do
so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest
rates than the market rates or no further mortgage of securities.

Financial leverage is considered to be favourable till such time that the rate of return exceeds
the rate of return obtained when no debt is used.

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The company not using debt to finance its assets has a higher DFL compared to that of a company using
it. Financial leverage does not exist when there is no fixed charge financing.

Total or combined leverage

The combination of operating and financial leverage is called combined leverage. Operating leverage
affects the firm’s operating profit EBIT and financial leverage affects PAT or the EPS. These cause wide
fluctuations in EPS. A company having a high level of operating or financial leverage will find a drastic
change in its EPS even for a small change in sales volume.

Companies whose products are seasonal in nature have fluctuating EPS, but the amount of changes
in EPS due to leverages is more pronounced.

The combined effect is quite significant for the earnings available to ordinary shareholders. Combined
leverage is the product of degree of operating leverage (DOL) and degree of financial leverage (DFL).

DTL = Q(S − V)
Q(S − V) − F − I − {Dp /(1 − T)}

Uses of degree of total leverage (DTL)

• Degree of total leverage (DTL) measures the total risk of the company as DTL is a combined
measure of both operating and financial risk
• Degree of total leverage (DTL) measures the variability of EPS

References
1. Financial Management by Khan Jain, 4th edition, 2005
2. Financial Management by I. M. Pandey, 9th edition, 2005
3. Financial Management by Prasanna Chandra, 6th edition, 2005
4. Financial Management by Shashi Gupta and Neeti Gupta, 2nd edition,2008
5. Financial Management by Rustogi, first edition, 2010.

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