Chapter Six

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

It means the entire left side of the It means only the long-term
balance sheet. liabilities of the company.
Financial structures consist of all It consists of debt and equity
sources of capital
It will not be more important It is one of the major determinations
while determining the of value of 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
 Common Shares  Preference shares
   Bonds or Debentures
5.1.2. 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.

• Equity shares only.

• Equity and preference shares only.

• Equity and Debentures only.

• 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
The operating leverage indicates the impact of changes in
DOL 
%  in Sales

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
Total
EBIT Leverage

- Interest
EBT Financial Leverage

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

20
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.

22
 Webb’s DOL When Q = 30,000 Units
30,000($25  $7)
DOL   540,000 \ 270,000
30,000($25  $7)  $270,000
2.0

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.

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 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%.

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 Comparing operating leverage
Operating Leverage Financial Leverage

It is associated with investment It is associated with financing

activities of the company. activities of the company.

A percentage change in the profits A % change in taxable profit is the

resulting from % change in the sales result of % change in EBIT.

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

Tax rate and interest rate will not Financial leverage will change due
 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.
Cont’d……
 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.
%  in EPS
DCL 
%  in Sales
Q( P  V )
=
Q( P  V )  F  I
S  VC S  VC
= 
S  VC  F  I EBT
 %  in EBIT  %  in EPS 
=   
 %  in Sales  %  in EBIT 
= (DOL)(DFL)
 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
Thank you for your
cooperation!
Have a nice day
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

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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

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