Chapter 5

FINANCING DECISION

COMPILED BY:-GIRMA G. (MBAF)

5.1. The concept of capital structure
 Is the mix of different sources of long-term funds in the capitalization of the company.

 The term capital structure differs from financial structure.

 Capital structure is the permanent finance of the company represented primarily by

long-term debt and shareholder’s funds but excluding all short-term sources.

 Financial structure refers to the way the firm’s assets are financed.

◦ It includes both long-term as well as short-term sources of funds.

 Cont’d…..
Financing structure Capital structure
It includes both long-term and short-term It includes only the long-term sources of
sources of funds funds.

It means the entire left side of the balance It means only the long-term liabilities of the
sheet. company.

Financial structures consist of all sources of It consists of debt and equity

capital

It will not be more important while It is one of the major determinations of value of
determining the value of the firm the firm .

 capital structure is only a part of its financial structure.

 Cont’d ……

1
Capital structure

Fixed yield bearing

Variable yield bearing securities:
securities:  Preference shares
 Bonds or Debentures
 Common Shares
 Optimum Capital Structure

◦ Optimum capital structure is the capital structure or combination of debt

and equity, that leads to the maximum value of the firm.

 Objectives of Capital Structure

Decision of capital structure aims at the following two important
objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
Features of optimum capital structure:
 Profitability: The capital structure should be devised so as to maximize the profits of the
firm.
◦ The most profitable capital structure is that minimizes cost of financing and maximizes
earnings per share.

 Solvency: Capital structure is said to be optimum, when the firm is free of becoming
insolvent.
◦ Use of debt in excess capacity may result as insolvency situation for a firm in long
run.
 Cont’d…….

 Flexibility: Capital structure of the firm should be flexible, so as to mobilize

additional funds whenever required by the firm.

 Conservatism: Capital structure should be such that it should generate future

cash flows desirable by the firm.

 Control: Capital structure should be devised in such a way that it minimizes risk
of loss of control over the firm financial operations.
 Forms of Capital Structure
 Capital structure pattern varies from company to company and the availability
of finance.

 Normally the following forms of capital structure are popular in practice.

a) • Equity shares only.
b) • Equity and preference shares only.
c) • Equity and Debentures only.
d) • Equity shares, preference shares and debentures.
5.2. Leverage

 Every business requires additional capital for its operational performance,

 which is financed through issue of common shares or by increase the debt by

the creditors.

 Leverage is that portion of the fixed costs which represents a risk to the firm.
 Classification of leverage
 Leverage is classified into three components and they are
(1) Operating leverage,

(2) Financial leverage, and

(3) Composite (or combined) leverage.

 5.2.1. Operating leverage

 Operating leverage, a measure of operating(business) risk, refers to the fixed

operating costs found in the firm’s income statement.

 Business Risk: The riskiness inherent in the firm’s operations if it uses no debt.

 Business risk can be viewed as the variability of a firm’s Earnings Before

Interest and Taxes (EBIT)
 Cont’d…..
It is always observed that changes in sales volume or value bear direct effect of
the operating profits of the firm.

 Operating leverage is defined as “the process of operating profits varying

proportionately with change in the sales”.

 An increase in sales will bring more operating profits, and a decrease in

sales volume reduces the operating profits.
 Cont’d…..
 A firm is said to have a high degree of operating leverage, if it employs
greater amount of fixed cost than variable costs.

 Therefore it is essential to know that operating leverage is dependent on the

employment of proportion of fixed cost by the given firm.
 Cont’d……

 Operating leverage can be calculated by the following formula:

%  in EBIT
DOL 
%  in Sales
%  in EBIT
DOL 
%  in Sales

 The operating leverage indicates the impact of changes in sales on operating

income.
 Cont’d………
 A high degree of operating leverage indicates a small change in sales will have
drastic effect on the operating profits of the firm.

 Higher operating leverage is a risky situation for the firm, as the small
drop in sales volume or value; there can be excessive damage to profits
of the firm.
Financial leverage

Financial leverage, a measure of financial risk, refers to

financing a portion of the firm’s assets, bearing fixed financing
charges in hopes of increasing the return to the common
stockholders.

The higher the financial leverage, the higher the financial risk,
and the higher the cost of capital.
 Financial risk
 Debt causes financial risk because it imposes a fixed cost in the form of
interest payments.

 The use of debt financing is referred to as financial leverage.

 Financial leverage increases risk by increasing the variability of a firm’s

return on equity or the variability of its earnings per share.
 Operating leverage can be calculated by the following formula:

% in EPS
DFL 
% in EBIT
EBIT
=
EBT
 Leverage and the Income Statement
Sales
- Fixed costs Operating Leverage
- Variable costs
EBIT Total
- Interest Leverage
EBT Financial Leverage
- Taxes
EAT

Note: EPS = EAT/(# shares) [assuming no pfd. stock]

19
Leverage Analysis: An Example Webb’s Incorporated Income Statement Year
Ended December 31, 2002)

Sales (30,000 units @ $25) $ 750,000

- Variable costs ($7 per unit) (210,000) 540,000
- Fixed costs (270,000)
EBIT $ 270,000
- Interest expenses (170,000)
EBT $ 100,000
- Taxes (34,000)
EAT $ 66,000

Given 20,000 shares outstanding: EPS = $66,000/20,000 = $3.30

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Degree of Operating Leverage
%  in EBIT
DOL 
%  in Sales
Q( P  V ) S  VC
= 
Q( P  V )  F S  VC  F
S  VC
=
EBIT

 Note: If F = 0, DOL = 1 (i.e., without any F, the % change in EBIT would be equal
to the % change in sales). By employing F, the firm’s % change in EBIT will be
greater than the % change in sales.
21
 Webb’s DOL When Q = 30,000 Units

30,000($25  $7)
DOL   540,000 \ 270,000  2.0
30,000($25  $7)  $270,000

 For every 1% change in sales, EBIT will change 2%.

 Operating Leverage is Risky: If sales increase 5%, a DOL of 2.0 indicates

that EBIT would increase 10%. On the other hand, if sales decline 7%, a
DOL of 2.0 indicates that EBIT would decline 14%.

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 Degree of Financial Leverage
%  in EPS
DFL 
%  in EBIT
EBIT
=
EBT

 Note: If interest expense = 0, DFL = 1.0 (i.e., without any debt financing, the % change in
EPS would be equal to the % change in EBIT).

 By incurring interest expense (debt financing) the firm’s % change in EPS will be
greater than the % change in EBIT.
01/07/2023 23
 Webb’s DFL When Q = 30,000 Units
$270,000
DFL   2.7
$270,000  $170,000

 For every 1% change in EBIT, EPS will change 2.7%

 Financial Leverage is Risky: If EBIT increases 2%, a DFL of 2.7 indicates that EPS would
increase 5.4%.

 On the other hand, if EBIT declines 4%, a DFL of 2.7 indicates that EPS would decline
10.8%. 01/07/2023 24
 Comparing operating leverage
Operating Leverage Financial Leverage

It is associated with investment activities of the It is associated with financing activities of the
company. company.

A percentage change in the profits resulting from A % change in taxable profit is the result of %
% change in the sales change in EBIT.

It depends upon FC and VC. It depends upon the operating profits

Tax rate and interest rate will not affect the Financial leverage will change due to tax rate
 Combined leverage
 When the company uses both financial and operating leverage to magnification of any
change in sales into a larger relative changes in earning per share.

 Combined leverage express the relationship between the revenue in the account of sales
and the taxable income.

 DCL is the % change in a firm’s earning per share (EPS) results from one percent change
in sales.

 This is also equal to the firm’s degree of operating leverage (DOL) times its degree of
financial leverage (DFL) at a particular level of sales.
 Cont’d…….

 Note: If F = 0, and I = 0, DCL = 1.0 (i.e., without F or I the %

change in EPS would be equal to the % change in sales).

 By employing F or I (or both), the firm’s % change in EPS will

be greater than the % change in sales.
Webb’s DCL When Q = 30,000 Units

30,000(25  7)
DCL 
30,000(25  7)  270,000 170,000
= (DOL)(DFL)
= (2)(2.7)
= 5.4
Illustration of Leverage Effects
(A 10% Increase in Sales for Webb’s Inc.)
Bef. Sales Inc.
Sales (33,000 units @ $25) $ 825,000 $ 750,000
 Variable costs ($7 per unit) (231,000) (210,000)
 Contribution 594,000 540,000
- Fixed costs (270,000) (270,000)
EBIT $ 324,000 $ 270,000
- Interest expense (170,000) (170,000)
EBT $ 154,000 $ 100,000
- Taxes ( 52,360) (34,000)
EAT $ 101,640 $ 66,000

EPS = $101,640/20,000 = $5.082 EPS = $3.30

01/07/2023 29
DOL = 2.0
324,000  270,000
%  in EBIT =  .2
270,000
= 2(%  in sales) = 20%
DFL = 2.7
5.08 - 3.30
%  in EPS = = .54
3.30
= 2.7(%  in EBIT) = 54%
DCL = 5.4
%  in EPS = 5.4(%  in sales) = 54%
Why should we care about capital structure?

 By altering capital structure firms have the opportunity to change their cost
of capital and – therefore – the market value of the firm

01/07/2023 31
THE END OF CH4
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