CHAPTER SIX

6. LEVERAGE AND
CHAPTER
CAPITAL STRUCTURE
6 Discussion Points:
Introduction
Capital Structure Defined
Operating Leverage
Measuring the Degree of Operating Leverage
(DOL)
Meaning of Financial Leverage
Measuring the Degree of Financial Leverage (DFL)
Total Leverage
Determining the Optimum Capital Structure
I. Introduction
Every time the firm makes an
investment decision, it is at the
Given the capital same time making a financing
budgeting decision decision also. For example, a
of a firm, it has to decision to build a new plant or
decide the way in to buy a new machine implies
specific way of financing that
which the capital
project. Should a firm employ
projects will be equity or debt or both? What are
financed. implications of the debt equity
mix? What is an appropriate mix
of debt and equity?
 …Cont’d
Introduction Cont’d
Capital Structure Defined
The assets of a company can be financed either by increasing
the owners’ claims or the creditors’ claims. The owners’ claims
increase when the firm raises funds by issuing ordinary shares or
by retaining the earnings; the creditors’ claims increase by
borrowing.
The various means of financing represent the financial structure
of an enterprise.
The term capital structure is used to represent the
proportionate relationship between debt and equity. Equity
includes paid-up share capital, share premium & reserves and
surplus (retained earnings).
 …Cont’d
Introduction Cont’d
 The financing or capital structure decision is a significant
managerial decision. It influences the shareholders
return and risk. Consequently, the market value of the
share may be affected by the capital structure decision.

The company will have to plan its capital structure

initially at the time of its promotion. Subsequently, when
funds are to be raised to finance investments, a capital
structure decision is involved.
 …Cont’d
Introduction Cont’d
 The company’s policy The new financing
to retain or distribute decision of the
earnings affects the company may affect its
owners’ claims. debt – equity mix. The
Shareholders’ equity debt – equity mix has
position is
implications for the
strengthened by
retention of earnings.
shareholders’ earnings
Thus, the dividend and risk, which in turn,
decision has a bearing will affect the cost of
on the capital structure capital and the market
of the company. value of the firm.
 …Cont’d
Introduction Cont’d
The management of a company should seek answers to the
following questions while making the financing decision:
 How should the investment project be financed?
 Does the way in which the investment projects are financed
matter?
 How does financing affect the shareholders’ risk, return and
value?
 Does there exist an optimum financing mix in terms of the
maximum value to shareholders of a company?
 Can the optimum financing mix be determined in practice for a
company?
 What factors in practice should a company consider in designing
its financing policy?
II. Operating Leverage
 If fixed operating costs are present in a firms cost structure,
so is operating leverage. Therefore, operating leverage arises
from the firm’s use of fixed operating costs.
 Operating leverage is the responsiveness of the firm’s EBIT to
fluctuations in sales.
 It refers to the magnification of gains and losses in EBIT by
changes that occur in sales, or
 Operating leverage refers to the potential use of fixed
operating costs to magnify the effects of changes in sales on
the firm’s EBIT.
 (Operating leverage Cont’d)

Example
To illustrate, assume that Recter Co. has fixed operating costs
of Birr 2,500, unit selling price of Birr 10, and variable operating
cost per unit of Birr 5. Now to see the impact of operating
leverage, let’s assume some changes in sales volume and see
what will happen to the firm’s EBIT as a result. Let’s assume
two changes:
Case 1: a 50% increase in sales, and
Case 2: a 50% decrease in sales.
 (Operating leverage Cont’d)

The table below shows the resultant change in EBIT from the
two changes in sales.
Table 5.1: Illustration – Operating Leverage
Case Sales in Increase/ EBIT Increase(decr
Units Decrease in ease in EBIT
sales
Normal 1,000 - 2,500 -
I 1,500 50% 5,000 100%
II 500 (50%) 0 (100%)
We can see that in Case 1, a 50% increase in sales (from 1,000
to 1,500 units) results in a 100% (from Birr 2,500 to 5,000)
increase in EBIT.
 (Operating leverage Cont’d)

 In Case 2, a 50% decrease in

sales result in a 100% decrease
in EBIT. Thus, we see that the
rate of change in EBIT is more
than proportional to the
corresponding change in sales.
That is, a 50% change in sales is
magnified in to 100% change in
EBIT.
 It is the existence of fixed
operating costs that magnifies
the effects of a given change in
sales on the EBIT.
 (Operating leverage Cont’d)
The higher the percentage of
fixed costs to total costs in a firm’s
cost structure, the greater the
firm’s degree of operating leverage,
and then the higher the
responsiveness of EBIT to a given
change in sales.
Operating leverage is related to
the firm’s business risk, which
refers to the risk inherent in the
firm’s investments – the
uncertainty surrounding sales and
costs.
(Operating leverage Cont’d)
 (Operating leverage Cont’d)

 The meaning of a 2.0 DOL is

that from the current base
sales level, for every 1 percent
change in sales within the
relevant range, there will be a
2 percent change in EBIT in
the same direction as the
sales change.
 As long as DOL is greater than
1, there is an operating
leverage.
III. Meaning of Financial Leverage
 Financial leverage results from the presence of fixed-
financing costs in the firm’s capital structure.
 The fixed-cost financing sources are:
debt (requiring interest payments),
preferred stock (requiring the company to make
preferred dividend payments), and
leases (which require specified lease payments).
 (Operating leverage Cont’d)
The financing cost on these capital sources, interest,
preferred stock dividends, and lease payments must
be paid regardless of the amount of EBIT available to
pay them.
Financial leverage is the responsiveness of the firm’s
earnings per share (EPS) to changes in EBIT.
 (Financial Financial
(Measuring LeverageCont’d)
Cont’d)

Unlike interest and lease payments, preferred dividend

payments are not tax deductible. Therefore, a Birr paid in
preferred dividends is more costly to the firm than a birr paid
in interest or lease payments.
Dividing any preferred dividend paid by (1 – T) accounts for
this and thus puts interest, lease, and preferred dividend
payments on an equivalent basis.

The degree of financial leverage reflects the leverage that is

due solely to the firm’s financing policy.
 (Financial Leverage Cont’d)

 The effect of financial

leverage is to magnify
changes in EBIT into
larger changes in EPS.
Thus, in effect, financial
leverage is second stage
leverage, taking up
where operating
leverage, which affects
EBIT, leaves off.
(Measuring
(Financial Financial
LeverageCont’d)
Cont’d)
 (Measuring
(Financial Financial
LeverageCont’d)
Cont’d)
 For example, if a firm
has a DOL of 2.25 and a
DFL of 1.4, the DCL will
be 2.25 times 1.4 =
3.15. This means that
for every 1 percent
change in sales, EPS will
change 3.15 percent in
the same direction. This
magnification is the
result of both operating
leverage and financial
leverage.
 V. Determining the Optimal Capital Structure

 It is generally believed that the value of the firm is maximized

when the weighted average cost of capital (WACC) is
minimized.

The capital structure where WACC is minimum is the point of

optimal financial leverage and hence of optimal capital structure.
 (Determining the Optimal Cont’d)

The Theory of Capital Structure

How should the firm go about choosing its debt/equity
ratio? Here, as always, we assume that the guiding
principle is to choose the course of action that maximizes
the value of a share of stock. This is essentially the same
as maximizing the value of the whole firm.

The important point here is, what happens to the

weighted average cost of capital (WACC) when we vary the
amount of debt financing or the debt/equity ratio.
 (Determining the Optimal Cont’d)

 A primary reason for studying

the WACC is that the value of
the firm is maximized when
the WACC is minimized.
 The WACC is a discount rate
that is appropriate for the
firm’s overall cash flows. Since
values and discount rates
move in opposite directions,
minimizing the WACC will
maximize the value of the
firm’s cash flows.
 (Determining the Optimal Cont’d)

 Thus, we will choose the firm’s capital structure at

the point where the WACC is minimized. For this
reason, we will say that one capital structure is
better than another if it results in a lower WACC.
 Further, we say that a particular debt/equity ratio
represents the optimal capital structure if it results
in the lowest possible WACC. This is sometimes
called the firm’s target capital structure as well.