Capital Structure

Dr. Erandi Abeywardana

Business FINANCE
MOBS 55073
Master of Business Studies

Department of Commerce and Financial Management

Faculty of Commerce & Management Studies
University of Kelaniya

1
Learning Outcomes
At the end of the session students will be able to;
• distinguish between operating leverage and financial leverage
• discuss the effect of leverage on firm value
• discuss capital structure theories

2
 What is Capital Structure?
• Capital structure refers to the kinds of securities and the proportionate
amounts that make up capitalization.
• It is the mix of different long-term sources such as equity shares,
preference shares, debentures, long-term loans and retained earnings.
• Deciding the suitable capital structure is the important decision of the
financial management because it is closely related to the value of the
firm.

3
 Optimal capital structure
• Optimal capital structure may be defined as the capital structure or
combination of debt and equity, that leads to the maximum value of
the firm.
• In optimal capital structure, the weighted average cost of capital is
minimum and value of the firm is maximum.
• Decision of capital structure aims at the following two important
objectives:
• Maximize the value of the firm (or MPS).
• Minimize the overall cost of capital.

4
Test Your Knowledge 1
The optimal capital structure is
A) the funding mix that will maximize the company’s value.
B) the mix of items on the right-hand side of the company's balance sheet.
C) the mix of funds that will minimize the firm's beta.
D) the mix of securities that have more equity.

5
 Leverage
• Leverage refers to the effects that fixed costs have on the returns that
shareholders earn; higher leverage generally results in higher, but
more volatile returns.

• Leverage consist with

- Operating Leverage
- Financial Leverage

6
 Operating Leverage (OL)
• OL refers to the use of fixed operating costs in the process of
magnifying operating income (EBIT)
• OL is concerned with the relationship between the firm’ s sales
revenue and its earnings before interest and taxes (EBIT) or operating
profits.
• Degree of Operating Leverage (DOL) is a quantitative measure of the
‘sensitivity’ of a firm’s Operating Profit to a change in the firm’s sales.
DOL = Contribution/EBIT

7
Test Your knowledge 2

• Use following information to calculate degree of operating leverage of

firm X and Y and give your comments.

Particulars Firm X Firm Y

Sales 100,000 100,000
Variable Costs 75,000 75,000
Fixed Operating Costs 10,000 15,000

8
Financial Leverage
• Use of the fixed-charges sources of funds such as debt and
preference capital alone with the owners’ equity in the capital
structure, is described as financial leverage or gearing.
• Measures of Financial Leverage.
Debt Ratio =
D/D+E (D+E is value of the company)
Debt-Equity Ratio
D/E

9
Financial Leverage and Shareholders’ Return

• A company uses financial leverage to magnify the

shareholders’ returns. Therefore, cost of fixed-charges funds
have to be lower than the firm’s rate of return on assets.
Therefore, EPS and ROE are the important figures for analyzing
the impact of financial leverage.

( EBIT − INT )(1 − T )

EPS =
N
( EBIT − INT )(1 − T )
ROE =
E

10
Test your Knowledge 3

• EX: EBIT = 120000, Plan A: 50000 ordinary shares of Rs 10. Plan B:

25000 ordinary shares of Rs 10 and borrow Rs. 250000 at 15%. Tax
rate is 50%.
You are required to show the effect of financial plan on EPS and ROE

11
Effect of Financial Plan on EPS and ROE: constant EBIT

All Equity Debt-equity

EBIT 120000 120000
Less: Interest 0 37500
PBT = EBIT-INT 120000 82500
Less: Taxes, T(EBIT-INT) 60000 41250
PAT=(EBIT-INT)(1-T) 60000 41250
Total earnings of investors(PAT+INT) 60000 78750
Number of shares 50000 25000
EPS 1.2 1.65
ROE 12% 16.5%

12
Interest Tax Shield

• The interest charges are tax deductible and therefore, provide tax
shield, which increases the earnings of shareholders.
• Interest tax Shield= Tax rate* Interest
= 0.5*37500= 18750

13
Advantages of Debt

• Interest is tax deductible (lowers the effective cost of debt)

• Debt-holders are limited to a fixed return – so stockholders do not
have to share profits if the business does exceptionally well
• Debt holders do not have voting rights

14
 Degree of Financial Leverage (FL)
Degree of Financial Leverage (DFL) is a quantitative measure of the
‘sensitivity’ of a firm’s EPS to a change in the firm’s EBIT.
DOL = EBIT/EBT

15
Test Your knowledge 4

• Use following information to calculate degree of financial leverage of

firm X and Y and give your comments.
Particulars Firm X Firm Y
Sales 100,000 100,000
Variable Costs 75,000 75,000
Fixed Operating Costs 10,000 15,000
Interest 1,000 2,000

16
 Leverage and the Income Statement
Sales
- Fixed costs
Operating Leverage
- Variable costs
EBIT Total
Leverage
- Interest
EBT Financial Leverage
- Taxes
EAT
Note: EPS = EAT/(# shares) [assuming no pfd. stock]

17
Test your knowledge 5
Calculate the Degree of Operating Leverage, Degree of Financial
Leverage and the degree of Combined Leverage for the following firms
and interpret the result.

A B C
Unit selling price (Rs.) 3 25 0.50
Unit variable cost (Rs.) 1 7.50 0.10
Fixed Cost (Rs.) 350,000 700,000 75,000
Interest (Rs.) 25,000 40,000 NIL
Output 300,000 75,000 500,000

18
 Capital Structure Theories
• Use to explain the interrelationship among Capital Structure,
Cost of Capital and the value of the firm.
• Focus on
-Leverage effect can reduce the overall Cost of Capital of
the firm.
- Leverage effect can enhance the value of the firm.

19
 Net Income Approach (NI)
• The firm is able to reduce its Cost of Capital (K0) and increase its total
valuation (V = D + E) as it increases the degree of Leverage, i.e. D/V.

Assumptions
1. The cost of Debt Capital (Kd) and the cost of Equity Capital (Ke) will
remain constant
2. The cost of Debt Capital (Kd) is always lower than the cost of Equity
Capital (Ke), i.e. Kd < Ke.
3. The risk perception of the investors does not change with the change
in Capital Structure
4. There is no corporate taxes
20
NI Approach Graphical Presentation
Various Cost of Capital (Kd, Ke and Ko)

Ke
Ko

Kd

Degree of Leverage (D/V)

21
NI Approach – Formulars to Use

Value of Firm V= E + D

V = Value of firm
E = Market value of equity
E = NI/Ke
NI= Earnings available to equity shareholder
Ke= Cost of equity/equity capitalization rate
• D = Market value of debt

22
Test Your Knowledge 6
X Ltd. has an annual EBIT of Rs. 135,000. Currently, it has 70,000 equity shares of
Rs.10 per share and 3,000, 8% Debentures of Rs. 100 each with 30% of degree of
leverage. The Equity Capitalisation rate is 12%.
In order to exploit the Trading on Equity advantage, the firm is contemplating to
increase the proportion of Debt Capital to 50% or to 60%. For this, firm is ready to
issue new 8% debentures and buyback equity shares accordingly.

What will be the effects of these financial decisions on the value of the firm and
its overall cost of capital?
Consider NI approach.

23
Net Operating Income (NOI) Approach
The value of a firm is not affected by any change in its Capital Structure.
In other words, it is not possible to change the value of any firm by
changing the debt-equity mix in the total capital.

Assumptions
• The cost of debt and overall cost of capital remains constant;
• There are no corporate taxes;
• The market capitalizes the value of the firm as a whole

24
NOI Approach Graphical Presentation
Various Cost of Capital (Kd, Ke and Ko)
Ke

Ko

Kd

Degree of Leverage (D/V)

25
NOI Approach – Formulars to Use
Value of Firm (V) V= EBIT/Ko
• V = Value of the firm
• EBIT = Earnings before interest and tax
• K0 = Overall cost of capital

Value of Equity (E) E=V-D D = Market Value of Debt

Cost of Equity (Ke) Ke = EBT/E or

Ke = Ko + ((Ko – Kd) X D/E) 26
Test Your Knowledge 7
Arosh Ltd. has an expected Net Operating Profit of Rs.240,000. It has
Rs.500,000, 9% Debt Capital. The overall capitalization rate is 12%.
(a) Calculate the value of the firm and Equity Capitalization rate under
NOI approach.
(b) If the firm decides to raise its Debt Capital by an additional
Rs.300,000 and use such proceeds to buy-back the existing equity
shares, then what will be the effect of such a policy on the value of the
firm and Equity Capitalization rate?

27
Modigliani and Miller Approach-Without tax:
Propositions I

MM Proposition I
The market value of a company is not affected by
the capital structure of the company.

Therefore, capital structure is irrelevant.

VL=Vu
VL = Value of levered firm, VL = Value of Unlevered firm

28
Fundamental Assumptions

The theory relies on two fundamental assumptions:

1. The cash flows that a firm generates are not affected by how the
firm is financed.
2. Financial markets are perfect

29
Cost of Capital and Capital Structure: M&M Theory

30
Cost of Capital and Capital Structure: M&M Theory

Debt-to-Equity Ratio Weighted Average Cost of Capital Cost of Debt Cost of Equity
0.00 10% 8% 10.00%
0.11 10% 8% 10.22%
0.25 10% 8% 10.50%
0.43 10% 8% 10.86%
0.67 10% 8% 11.33%
1.00 10% 8% 12.00%
1.50 10% 8% 13.00%
2.33 10% 8% 14.67%
4.00 10% 8% 18.00%
9.00 10% 8% 28.00%

Cost of D
Legend: = kwacc + (kwacc − kd )  
 Cost of Debt to   Cost of Equity to  Equity (ke ) E 
kwacc =    +  
Debt (kd ) Value (D /V ) Equity (ke ) Value (E /V ) where D /E is the ratio of debt to equity.

31
Capital Structure, the Cost of Equity, and the Weighted Average Cost of
Capital

Because firm value and firm cash flows are unaffected by the
capital structure, this implies that he firm’s WACC is also
unaffected.

Cost of D
= kunlevered + (kunlevered − kd )  
Equity (ke ) E 

32
Test Your Knowledge 8
If it uses no financial leverage, the cost of capital is 11%. It has a debt-
to-equity ratio of 1.0, and the cost of debt is 8%. What is the cost of
equity? What is the WACC

33
Why Capital Structure Matters in Reality?

Financial managers care a great deal about how their firms are
financed. Indeed, there can be negative consequences for firms that
select an inappropriate capital structure, which means that, in reality,
at least one of the two M&M assumptions is violated.

34
Violation of Assumption 1
There are three important reasons why the firm’s capital structure
affects the total cash flows available to its debt and equity holders:
1. Interest is a tax-deductible expense, whereas dividends are not.
Thus, after taxes, firms have more money to distribute to their debt
and equity holders if they use debt financing.
2. Debt financing creates a fixed legal obligation. If the firm defaults
on its payments, the firm will incur the added cost that the
bankruptcy process entails.
3. The threat of bankruptcy can influence the behavior of a firm's
executives as well as its employees and customers.

35
Violation of Assumption 2
Assumption 2 is clearly violated in reality. Transaction costs can be
important and because of these costs, the rate at which investors can
borrow may differ from the rate at which firms can borrow. When this
is the case, firm values may depend on how they are financed.

36
Corporate Taxes and Capital Structure
Interest payments are tax deductible (and dividends are not). So if the
before-tax cash flows are unaffected by how the firm is financed, the
after-tax cash flows will be higher if the firm's capital structure includes
more debt and less equity.

37
Corporate Taxes and Capital Structure

Consider two firms identical in every respect except for their capital
structure.
• Firm A has no debt and has total equity financing of Rs.2,000,000.
• Firm B has borrowed Rs.1,000,000 on which it pays 5% interest and raised the
remaining Rs.1,000,000 with equity.
• Each firm has operating income of Rs.200,000.
• The corporate tax rate is 25%.

38
Corporate Taxes and Capital Structure
Blank Firm A Firm B Note that Firm B pays
(Rs.000’) (Rs.000’) Rs.37,500 in taxes, which
is Rs.12,500 less than
Net operating income (EBIT) 200 200 Firm A. This is a result of
Interest expense 0.00 (50) the fact that the
Rs.50,000 Firm B paid in
Earnings before taxes 200 150 interest is tax-deductible.
Income taxes (50) (37.50)
Net income 150 112.50
The Rs.12,500 can be traced to the tax benefits of interest payments, 0.25 ×50,000 = 12,500 This is
referred to as interest tax savings.
These tax savings add value to the firm and provide an incentive to the firm to include more debt.

The tax deductibility of interest expense causes the firm's weighted average cost of capital to decline
as it includes more debt in the capital structure.
The cost of equity with corporate tax

Cost of  D  Tax  

= kUnlevered Equity + (kUnlevered Equity − kd )     1 − 
Equity (ke )    
E Rate 

Test Your Knowledge 9

JNK's cost of capital if it uses no financial leverage is 11%. It has a debt
equity ratio of 1.0, the cost of debt is 8% before taxes, and the tax rate
is 40%. What will be the cost of equity and weighted average cost of
capital if the debt to equity ratio is 1 (i.e. 50% debt and 50% equity).

40
Bankruptcy and Financial Distress Costs

Even though debt provides valuable tax savings, a firm cannot keep on
increasing debt. The downside of using debt financing quickly becomes
apparent when the firm’s debt obligations exceed it's ability to
generate cash. The firm will need to work out a deal with its bankers
and bondholders to restructure its debt, or the firm might be forced
into bankruptcy and incur financial distress costs.

41
The Tradeoff Theory and the Optimal Capital
Structure
Two factors can have a material impact on the role of capital structure
in determining firm value:
• Interest expense is tax deductible. (benefit of debt)
• Debt makes it more likely that firms will experience financial distress costs.
(drawback of debt)
• Firms must trade off the benefit and drawback of debt while making
financing decisions.

42
The Cost of Capital and the Tradeoff Theory

43
Test Your Knowledge 10
The tradeoff theory of capital structure management assumes
A) no corporate income taxes.
B) cost of equity remains constant with an increase in financial
leverage.
C) firms might fail.
D) none of the above.

44
45