Chapter 1

Capital
Structure Policy
and Leverage 1
Introduction
• Any business or a company requires capital to acquire
assets.
• These assets could also be obtained with loans from
financial institutions and other sources.

• The Capital structure refers to the kind and

proportion of different securities for raising
funds.

• After deciding about the quantum of funds required it

should be decided which type of securities should be
2
• Once the firm has taken the investment decision and
committed itself to new investment, it must decide
the best means of financing these commitments.

• Since, firms regularly make new investments; the

needs for financing and capital structure decisions
are ongoing, hence, a firm will be continuously
planning for new financial needs.

• A finance manager has to select such sources of funds

which will make optimum capital structure. 3
• After preparing a capital structure, an appropriate
source of finance is selected.

• Various sources, from which finance may be raised,

include share capital, debentures, financial
institutions, commercial banks, public deposits, etc.

• If finances are needed for short periods then banks,

public deposits and financial institutions may be
appropriate; on the other hand, if long-term finances
are required then share capital and debentures may 4
• The capital structure decision centers on the
allocation between debt and equity in financing
the business needs.

• An efficient mixture of capital reduces the price of

capital.
• The Lesser cost of capital increases net economic
returns which ultimately increase business value.
• An unleveled business uses only equity capital.
• A levered business uses a mix of equity and various
forms of other liabilities.
5
 Factors that influence capital structure
decisions
• Financial Leverage:
– It is the use of long term fixed interest bearing debt
and preference share capital along with equity
share capital.
• Growth and Stability of Sales:
– If the sales are expected to remain fairly stable, it
can raise a higher level of debt.
– Stability of sales ensures that the firm will not face
any difficulty in meeting its fixed commitments of
interest payment and repayments of debts. 6
• Cost of Capital:
– Cost of capital refers to the minimum rate of return
expected by its suppliers.
– The capital structure should also provide for the
minimum cost of capital. Usually, debt is cheaper
source of finance compared to preference and
equity. Preference capital is cheaper than equity
because of lesser risk involved.
• Cash flow Ability to Service the Debt:
– A firm which shall be able to generate larger and
stable cash inflows can employ more debt in its
capital structure as compared to the one which has
7
unstable and lesser ability to generate cash inflows.
• Nature and Size of Firm:
– Small companies have to depend upon owned capital, as it
is very difficult for them to raise ling term loans on
reasonable terms.
• Flexibility:
– Capital structure of the firm should be flexible. i.e. it should
be capable of the being adjusted according to the needs of
changing conditions.
• Requirement of Investors:
– It is necessary to meet the requirement of both institutional
as well as private investors when debt financing is used.
• Capital Market Conditions:
– The choice of securities is also influenced by the market
8
• Assets structure:
– If fixed assets constitute a major portion of the total
assets of the company, it may be possible for the
company to raise more of long term debts.
• Period of Financial:
– If finance is required for the limited period,
debentures should be preferred. If funds are needed
for permanent basis, equity share capital is more
appropriate.
• Purpose of financing:
– If funds are required for the productive purpose,
debt financing is suitable as interest can be paid out
9
• Personal Consideration:
– Management, which is experienced and very
enterprising, does not hesitate to use more of debts
in their financing as compared to less experienced
and conservative management.

• Corporate Tax Rule:

– High rate of corporate taxes on profits compels the
companies’ to prefer debt financing, because
interest is allowed to deduct while computing
taxable profits. 10
Business Risk and Financial Risk
1. Business risk can be defined as the risk associated
with not being able to earn enough to pay off
the business's expenses.
• The firm’s level of business risk also strongly affects
the type of financing that should be used.

• The greater the business risk, the less desirable debt

financing usually becomes relative to common stock
financing.

• In other words, equity financing is safer in that 11

2. The financial risk refers to the risk of the firm not
being able to cover its fixed financial costs.
– Financial risk is the possibility that the use of debt to
finance operations will have a negative impact on earnings.

12
Operating leverage
• Operating leverage is the degree to which a project or
firm is committed to operating fixed production costs.
• It can be defined as the company’s ability to use
fixed operating costs to magnify the effects of
changes in sales on its EBIT.
• Operating leverage consists of two important costs
viz., fixed cost and variable cost.
– When the company is said to have a high degree of
operating leverage if it employs a great amount of fixed
cost and smaller amount of variable cost.
– Thus, the degree of operating leverage depends upon the
amount of various cost structure. 13
Degree of operating leverage (DOL) measures the
responsiveness of operating income (EBIT) to change in
the level of output (Q) and gives management an
indication of the response in profits it can expect if the
level of sales is altered.
DOL= or
DOL = = 1 +
Or DOL =

14
Example
• The installed capacity of ABC Company’s factory is
500 units. Actual capacity used is 300 units. Selling
price per unit is br. 15. Variable per is br.7 per unit.
Calculate the Degree of Operating leverage in each of
the following three Situations
(1) When fixed costs are br. 500
(2) When fixed costs are br.1000
(3) When fixed costs are br. 1500
15
 Case (1) Case (2) Case
(3)
Total sales (300 units* br.15) 4500 4500
4500
Less: Total variable cost (300units*7)2100 2100
2100
Contribution 2400 2400
2400
Less: fixed costs 500 1000
1500
EBIT 1900 1400
900
DOL 1.26 1.71
2.67 16
Example 2:
From the following particulars of ABC Ltd. Calculate operating
leverage.
Particulars Previous Year Current Year
2003 2004
Sales revenue 1,000,000 1,250,000
Variable cost 600,000 750,000
Fixed cost 250,000 250,000
• Calculation of EBIT on a Percentage Change
Solution:
Particulars 2003 2004 % change
Sales Revenue 1,000,000 1,250,000 25
Less: Variable cost 600,000 750,000 25
Contribution 400,000 500,000 25
Less: Fixed cost 250,000 250,000
EBIT 150,000 250,000 66.67 17
 DOL =
=
• Operating leverage 2.667 indicates that when, there
is 25 % change in sales, the change in EBIT is 2.667
times.

18
Financial leverage
• A firm may need long-term funds for long-term
activities like expansion, diversification,
modernization etc. , the financial managers job is to
compose funds.

• The use of fixed charges, sources of funds such as

debt and preference share capital along with the
equity share capital in capital structure is described
as financial leverage.

• Financial leverage is the ability of the firm to use

19
• Financial leverage associates with financing activities.
• The fixed charges do not vary with firm's EBIT.
• They must be paid regardless of the amount of EBIT
available to the firm.
• It indicates the effect on EBIT created by the use of fixed
charge securities in the capital structure of a firm.
• Financial leverage is computed by the following formula:
Financial Leverage =
• In other words, financial leverage may be defined as the
payment of fixed rate of interest for the use of fixed
interest bearing securities, to magnify the rate of return
as equity shares.
20
A Financial leverage may be positive or negative.

• High degree of financial leverage leads to high

financial risk.

• The financial risk refers to the risk of the firm not

being able to cover its fixed financial costs.

• Hence, the financial manager should take into

consideration, the level of EBIT and fixed charges
while preparing the firm's financial plan. 21
Example
• A firm has sales of 100,000 units at Br.10 per unit.
Variable cost of the produced products is 60 % of the
total sales revenue. Fixed cost is Br.200,000. The firm
has used a debt of Br.500,000 at 20 % interest.
Calculate the operating leverage and financial
leverage.

22
• Solution: Calculation of EBT
Particulars Amount (Br.)
Sales Revenue (100,000 units × Br.10 1,000,000
per unit)
Less: Variable cost (10,00,000 × 0.60) 600,000
Contribution 400,000
Less: Fixed cost 200,000
EBIT 200,000
Less: Interest (500,000 × 20 %) 100,000
Earning before tax (EBT) 100,000
Operating Leverage = =
Financial Leverage = =
23
Optimum Capital Structure
• It is the capital structure at that level of debt – equity
proportion, where the market value per share is
maximum and the cost of capital is minimum.
• Particular mix of debt and equity which maximizes the
value of the firm, is known as optimum capital
structure.
• Example: In considering the most desirable capital
structure of a company, Cost
Debt as a % of total Capital
a of
financial
Equity
manager
Cost of Debt
has
estimatedEmployed
the following. (%) (%)
0 10.0 6.0
10 10.0 6.0
20 10.5 6.0
30 11.0 6.5 24
40 12.0 7.0
• You are required to determine the optimal debt - equity mix or
optimal capital structure by the calculation of overall cost of
capital.
• Solution:
• Calculation
Equity Debtof Overall
Cost of Cost of Capital
Cost of Overall cost of Capital K =[K (W )
o e e
Equity
Weight Weight Debt +Kd(Wd)]×100
(Ke)
(We) (Wd) (Kd)

1.00 0.00 0.100 0.06 [(0.10 × 1.0) + (0.06 × 0.0)] × 100

= 10
0.90 0.10 0.100 0.06 [(0.10 × 0.90) + (0.06 × 0.10)]
× 100 = 9.6
0.80 0.20 0.105 0.06 [(0.105 × 0.80) + (0.06 × 0.20)] ×
• Here optimal capital structure is one, with 90=%
100 equity and 2510
9.68
 Introduction to the theory of capital structure
1. Net Income (NI) Approach
• According to this approach, capital structure decision is
relevant to the valuation of the firm.
• According to the theory it is possible to change the cost of
capital by changing the debt equity mix.
• A change in the capital structure causes a change in the
overall cost of capital as well as the value of the firm. The
formula to calculate the average cost of capital is as follows
or
Where,
- Ko is the average cost of capital - Kd is the cost of debt
- D is the market value of debt - Ke is the cost of equity
- E is the market value of equity
26
The NI approach is based on the following assumptions:
1. The use of debt does not change the risk of investors
and therefore, cost of debt (Kd) and cost of equity
(Ke) remains the same irrespective of the degree of
leverage.
2. Cost of debt is less than the cost of equity.
3. The corporate income tax does not exist
Example 1:
A Company’s expected net operating income ( EBIT ) is
Br. 100,000. The company has issued Br. 500,000, 10%
debentures at Br. 100 each. The cost of equity is 12.5%.
Assuming no taxes, find out the overall cost of capital
27
Solution
Net operating income (EBIT) ( Br.) 100,000
Less: Interest, on debentures ( Br.) 50,000
Earning available to ESH (NI) (Br.) 50,000
Cost of equity (Ke) 12.5%
E= Value of Equity shares (NI/Ke) (Br.) 400,000
(50,000/0.125)
Value of debt (D) (Br.) 500,000
Total Value of the firm ( E+D=V) ( Br.) 900,000
Overall cost of capital ( EBIT/V)
Alternatively, 11.1%
(100,000/900,000)
11.1%

28
• Assuming the market price per share to be Br. 100, there will
be 4000 shares of Br. 100 each. Find out the effect of increase
in leverage on the cost of capital (Ko) and value of the firm.
• Assume that the above company increases the debt from Br.
500,000 to Br. 600,000 and the cost of the debt and equity
remains at the same level. We can calculate the overall cost of
capital, value of the firm and the market value of equity
shares as shown below.
EBIT 100,000
Less: Int on debt 60,000
Earnings available to ESH ( NI) 40,000
Ke 0.125
Value of equity shares (NI/Ke) =E 320,000
(40,000/0.125)
Value of debt (D) 600,000 29
 Ko = EBIT = 100,000 = 10.87%
V 920,000
Alternatively Ko can be calculated as below:

10.87 %

30
Market Value of Equity Shares
• Before increasing the debt, there were 4000 ES of Br. 100
each
• Then the firm increased the debt by Br. 100,000 and used
the proceeds to retire equity shares. So the company
redeemed 1000 shares of Br. 100 each.
• So the number of shares outstanding is 4000 – 1000 =
3000 Therefore, value of 1 equity share is:
Br 106.67 3000
• So, the market value of equity shares has
increased to Br. 106.67.
• Generally, according to the NI
approach, as the debt content is 31
2.Net Operating Income Approach
• This is just the opposite to NI approach.
• According to NOI approach, the capital structure
decision is irrelevant and there is nothing like
optimum capital structure.
• All the capital structures are optimum.
• According to this theory, the market value of the
firm is not affected by the capital structure
changes. The market value of the firm is found by
capitalizing (dividing) the net operating income by the
overall cost of capital, which is constant. The market
value of the firm is obtained by using the following
32
formula.
• The overall cost of capital depends on the business
risks of the firm, which is assumed to be constant.
• NOI depends on the investments made by the
company and not on the capital structure
decisions.
• So, if NOI and Ko are constant, the value of the firm
must remain same regardless of leverage.

33
Assumptions
• The market capitalizes the value of the firm as a
whole. Thus, the split between debt and equity is
not important.
• The value of the firm is obtained by capitalizing NOI
by the Ko, which depends on the business risks. If
business risks is constant, Ko is also constant.

• The use of debt increases the risks of shareholders,

So, Ke increases with the leverage and eats
completely the advantage of low cost debt.
1. Cost of debt remains same regardless of leverage.
34
• The critical assumptions of this approach are that Ko
remains same regardless of the degree of leverage.
– The market capitalizes the value of the firm as a
whole and the split between debt and equity is
unimportant.
– The benefits from the increase in the use of cost
debt is completely offset (neutralized) by the
increases in the cost of equity. So even if the
leverage is increased, overall cost of capital
remains at the same level.

– When the company increases the leverage, the firm

becomes more risky and equity shareholders 35
Example
A company’s expected annual net operating income
(EBIT) is Br. 100,000. The company has 500,000, 10%
debentures. The overall cost of capital is 12.5%.
Calculate the value of the firm and cost of equity
according to NOI approach.
Solution:
Net operating income (EBIT) (Br.) 100,000
Overall cost of capital (Ko) 0.125
Total value of the firm (V=EBIT/Ko) (Br.) 800,000
(100,000/0.125)
Market value of the debt (D) (Br) 500,000
Total market value of the equity (E=V-D) (Br) 300,000

36
Market value of equity shares :
• Assuming the market price of shares to be Br. 100, there
are 3000 shares of Br. 100 each. If the company increases
the debt from Br.500,000 to Br. 600,000 the Ke and the
value of the firm are as below:

Net operating income (EBIT) (Br) 100,00

0
Overall cost of capital (Ko) 0.125
Total value of the firm (V=EBIT/Ko)(Br.) 800,00
(100,000/0.125) 0
Market value of debt (D) (Br.) 600,00
37
Market Value of the Equity Shares
• The firm has increased the debt by Br.100,000 and used
the proceeds to reduce equity capital. The number of
shares has reduced from 3000 to 2000. Therefore, the
price per share can be calculated as below:
Price per share = Total market value of the shares =
200,000 = Br 100 Number of shares
2000
• So, there is no change in the price per share, total
value of the firm and overall cost of the capital
when the leverage is changed. 38
Example 2:
A firm has an EBIT of Br. 200,000 and belongs to
a risk class of 10%. What is the value of equity
capital if it employees 6% debt to the extent of
30%, 40%, 50% of the total capital fund of Br.
1,000,000.

39
Solution:
The effect of changing debt proportion on the
cost of equity capital can be analyzed as follows:
30% Debt 40% Debt 50% Debt
EBIT Br. 200,000 200,000 200,000
Ko 10% 10% 10%
Value of the firm, V 2,000,000 2,000,000 2,000,000
Value of 6% Debt, D 300,000 400,000 500,000
Value of Equity (E=V-D) 1,600,000 1,500,000
1,700,000
Net Profit(EBIT – 182,000 176,000 170,000
Interest)
Ke (NP/E) 10.7% 11% 11.33% 40
The Ke of 10.7%, 11% and 11.33% can be verified
for different proportion of debt by calculating Ko
as follows:

41
Modigliani-Miller Approach (MM)
• MM theory relating to the relationship between cost of
capital and valuation is similar to the NOI approach.
• According to this approach, the value of the firm is
independent of its capital structure.
• However, there is a basic difference between the two.
• The NOI approach is purely a definitional term, defining the
concept without behavioral justification.

• MM approach provides analytically sound, logically

consistent, behavioral justification in favor of the
theory and considers any other theories of Capital structure
as incorrect. 42
Assumption
• Capital markets are perfect. This means,
– Investors are free to buy and sell securities.
– Inventors can borrow and lend money on the same
terms on which a firm can borrow and lend.
– There are no transaction costs.
– They behave rationally.
– Firms can be classified into homogenous risk
categories. All the firms within the same class will
have the same degree of business risks.

43
All the investors have the same expectations from a
firm’s NOI with which to evaluate the value of the firm.

• Dividends Payout ratio is 100% and there are no

retained earnings.

• There are no corporate income taxes. This assumption

is removed later.

44
Proof of MM Argument
• The value of a firm depends on its profitability and
risks.
• Similarly, according to the theory, cost of capital and
market value of the firm must be same regardless of
the degree of leverage.
• The operational justification for the MM hypothesis is
the “Arbitrage Argument”.

• The term arbitrage refers to the act of buying a

security in the market, where the price is less and
simultaneously selling it in another market where the
45
• Arbitrage process helps to bring equilibrium in the
market. Because of arbitrage, a security cannot be
sold at different prices in different markets.

• MM approach illustrates the arbitrage process with

reference to valuation in terms of two firms, which
are exactly similar in all aspects with respect to
leverage, so that one of them has debt in the capital
structure while other does not.

• Such homogenous firm’s are, according to MM, 46

• If the market value of the two firms which are exactly
same in all the respects, except with the leverage,
which is not equal, investors of the overvalued firm
would sell their shares, borrow additional funds on
their personal account and invest in the undervalued
firm, in order to obtain the investors for arbitrage is
termed as home-made or personal leverage.

• So investor undertaking arbitrage would be better off.

• This behavior of arbitrage will have investors of
overvalued firm.
• Arbitrage would be counting till the market prices of
47
two identical firms become identical.
Example:
Assume that there are two firms L and U which are
identical in all the respects except that, the firm L has
10% Br. 500,000 debentures. The EBIT of both the
firms are Br. 80,000. The cost of equity of the firm L is
higher at 16% and firm U is lower at 12.5%.

48
• The total market values of the firm are computed as
below. FIRM L FIRM U
EBIT 80,000 80,000
Less: Interest 50,000 -
Earnings available to ESH (NI) 30,000 80,000
Cost of equity (Ke) 0.16 0.125
Market value of equity shares 187,50 640,000
(E=NI/Ke) 0
Market value of debt 500,000 ------
Total value of the firm (V) 687,50 640,000
0
11.63 % 12.50 %
Thus, the total value of the firm which employed debt is more
than the value of the other firm.
According to MM, this previous arbitrage would start and 49
Working of the Arbitrage Process
• Suppose there is an investor X, who holds 10% of the
outstanding shares in the firm L.
• This means his holding amounts to Br. 18,750 and his
shares in the earning which belongs to equity shareholders
is Br. 3000 (10% of Br. 30,000).
• Mr. X will sell his holding in the firm L and invest money in
the firm U. The firm U has no debt in the capital structure
and hence, the financial risk to Mr. X would be less in the
firm U than firm L .

• In order to have the same degree of financial risk as of the

firm U, Mr. X will borrow additional funds equal to his
proportionate shares in substituted personal leverage 50 in
The position of Mr.X is summarized as below.
Firm L Investment amount (10% holding) 18,75
0
Dividend income (10% of 30000) 3,000

Firm U
Investment amount 18,750+50,000=6
8,750
• Less Interest on loan 5,000.00
• Return on Investment 3,593.75

51
• So Mr. X gets a higher income after shifting his
investment to company U (Br 3,000 and 3,593.75).
• His ROI increases from 16% to 19%.
• The other investors will also wish to make profit out
of arbitrage.
• This increases the demand for securities of the firm U
and will lead to increase in its price.
• At the same time, the price of the security of the firm
L will decline due to the selling pressure.
• This will continue till the prices of the securities of
the firms become identical.
52
Taxes: If the corporate taxes are taken into
consideration.
• MM argues that the value of the firm will increase
and cost of capital will decrease with leverage.

• Interest paid on the debt is tax deductible and

therefore, effective cost of debt is less than the
coupon rate of interest.

• Therefore, levered firm would have a greater

market value than the unlevered firm (cost capital
53
Trade-off theory
• This theory states that firms trade off the tax
benefits of debt financing against problems
caused by potential bankruptcy.
•
• Its purpose is to explain the fact that firms or
corporations usually are financed partly with debt and
partly with equity.

• It states that there is an advantage to financing with

debt, the tax benefit of debt and there is a cost of
financing 54
Using debt financing to constrain managers
• Agency problems may arise if managers and
shareholders have different objectives.
• Such conflicts are particularly likely when the firm's
managers have too much cash at their disposal.
• Managers often use excess cash to finance pet
projects or for perquisites such as nicer offices,
corporate cars, and others all of which may do little to
maximize stock Prices.

• Even worse, managers might be tempted to pay too

much for an acquisition, something that could cost 55
• By contrast, managers with limited "excess cash flow
are less able to make wasteful expenditures.
• Firms can reduce excess cash flow in a variety of
ways.
– One way is to funnel some of it back to shareholders
through higher dividends.

– Another alternative is to shift the capital structure

toward more debt in the hope that higher debt service
requirements will force managers to be more disciplined.

– If debt is not serviced as required, the firm will be forced

56
• Therefore, a manager is less likely to buy an
expensive new cars if the firm has large debt service
requirements that could cost the manager his or her
job.

• Of course, increasing debt and reducing free cash

flow has its downside: It increases the risk of
bankruptcy

• Higher debt forces managers to be more careful with

shareholders’ money, but even well-run firms can face
57
 END OF
CHAPTER
1 58