PART I : CAPITAL STRUCTURE AND PAYOUT POLICY

CH. I. CAPITAL STRUCTURE

CH. II. PAYOUT POLICY

Financial Management II (AcFn 3042) – Andualem Z.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

Chapter Outline
 Meaning of capital structure
 The capital structure question
 Factors that influence capital structure decisions
 Business and financial risk:
• Business risk and operating leverage
• Financial risk and financial leverage
 Determining the optimal capital structure
• EBIT/EPS analysis
• The effect of capital structure on stock price and the cost of capital
 Introduction to the theory of capital structure
• Modigliani and Miller Propositions, Trade-off theory, Signaling theory
• Using debt financing to constrain managers
Meaning of capital structure
 Meaning of Capital Structure

 Capital structure (What?)

• Refers to the mix (or proportion) of a firm’s permanent long-term source of
financing represented by debt, preferred stock, and common equity that is used
to finance the firm’s assets.
• Represent the proportionate relationship between debt and equity (i.e. debt-
equity mix or ratio): where equity includes paid-up share capital, share premium
and reserves and surplus (retained earnings).
• The percentage of each type of investor-supplied capital, with the total being
100%.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 Meaning of Capital Structure
Definition
 The mix of debt, preferred stock, and common equity that is used to finance the firm’s assets.…or
 The choice between debt and equity financing …………………the capital structure decision.
 Decision on the sources and amounts of financing
o Involves evaluating type of source, period of financing, cost of financing and the returns thereby
 Financing decisions raise money for investment.
Questions
 What long-term sources of finance are available for a firm?
 What mixture of equity and debt is best/how much to borrow?
 What are the least expensive sources of funds for the firm?
 How and where to raise the money?
 Optimal Capital Structure The capital structure that maximizes a stock’s intrinsic value.
Meaning of Capital Structure

• The term capital refers to Investor-supplied funds such as long- and short-term loans
from individuals and institutions, preferred stock, common stock, and retained
earnings.
 The Capital Structure Question
1. How should a firm go about choosing its debt-equity ratio?
• Can financing decisions create value?
2. What is an optimal capital structure? or What is the ratio of debt to equity
that maximizes the shareholders’ interests?
 The Capital Structure Question…
• The objective of a company is to maximize the value of the company and it is
prime objective while deciding the capital structure.
• Capital structure decisions refers to deciding:
1. the forms of financing (which sources to be tapped);
2. their actual requirements (amount to be funded); and
3. their relative proportions (mix) in total capitalization.
• Capital structure decision will decide weight of debt and equity and ultimately
overall cost of capital as well as the value of the firm.
• So capital structure is relevant in maximizing value of the firm and minimizing overall cost of
capital.
Factors that influence capital structure
decisions/design – Determinants of
Capital Structure – Checklist of Items
 Factors that influence capital structure decisions
 Choice of source of funds
- a firm has the choice to raise funds for financing its investment proposals from
different sources in different proportions. It can:
a) exclusively use debt (in case of existing company), or
b) exclusively use equity capital, or
c) exclusively use preference share capital (in case of existing company), or
d) use a combination of debt and equity in different proportions, or
e) use a combination of debt, equity and preference capital in different proportions,
or
f) use a combination of debt and preference capital in different proportions (in case
of existing company).
 Factors that influence capital structure decisions
 Choice of source of funds…
- the capital structure of a firm depends on a number of factors and these factors are of
different importance.
- the influence of individual factors of a firm changes over a period of time.
a) Sales growth and stability – a firm whose sales are relatively stable can safely take on
more debt and incur higher fixed charges than a company with unstable sales.
b) Asset structure (Cash flow ability) – holding other factors constant, a company is able
to take on more debt if it has more cash on the balance sheet.
 Factors that influence capital structure decisions…
c) Size of the firm
 Small firms
- find it very difficult to mobilise long - term debt, as they have to face higher rate of interest and
inconvenient terms;
- make their capital structure very inflexible and depend on share capital and retained earnings for
their long - term funds; cannot go to the capital market frequently for the issue of equity shares, as it
carries a greater danger of loss of control over the firm to others;
- sometimes limit the growth of their business and any additional fund requirements met through
retained earnings only.
 Large firms
- has relative flexibility in capital structure designing;
- has the facility of obtaining long - term debt at relatively lower rate of interest and convenient
terms; have relatively an easy access to the capital market.
 Factors that influence capital structure decisions…
d) Profitability – firms with very high rates of return on investment use relatively little
debt, i.e. their high rates of return enable them to do most of their financing with
internally generated funds.
e) Growth rate – other things the same, faster-growing firms must rely more heavily on
external capital.
f) Taxes – interest is a deductible expense, and deductions are most valuable to firms
with high tax rates. The higher a firm’s tax rate, the greater the advantage of debt.
g) Management attitudes – some managers tend to be relatively conservative and thus
use less debt than an average firm in the industry, whereas aggressive managers use a
relatively high percentage of debt in their quest for higher profits.
 Factors that influence capital structure decisions…

h) Market conditions – in the case of depressed conditions in the share market, the firm
should not issue equity shares but go for debt capital; On the other hand, under boom
conditions, it becomes easy for the firm to mobilise funds by issuing equity shares.
i) Control – control considerations can lead to the use of debt or equity because the type
of capital that best protects management varies from situation to situation.
In any event, if management is at all insecure, it will consider the control situation
(e.g. risk of dilution, risk of bankruptcy and loss of job, risk of takeover, etc.).
 Factors that influence capital structure decisions…
j) Financial flexibility
- flexibility means the firm's ability to adapt its capital structure to the needs of the
changing conditions.
- which from an operational viewpoint means maintaining adequate “reserve borrowing capacity.”
- capital structure should be flexible enough to raise additional funds whenever
required, without much delay and cost.
- the capital structure of the firm must be designed in such a way that it is possible to
substitute one form of financing for another to economise the use of funds.
- preference shares and debentures offer the highest flexibility in the capital structure,
as they can be redeemed at the discretion of the firm.
 Factors that influence capital structure decisions…
k) Cost of capital – an ideal pattern of capital structure is one that minimises cost of
capital structure and maximises earnings per share (EPS).
The overall cost of capital depends on the proportion in which the capital is
mobilised from different sources of finance.
l) Legal requirements
- the various guidelines issued by the government from time to time regarding the
issue of shares and debentures should be kept in mind while determining the capital
structure of a firm.
- these legal restrictions are very significant as they give a framework within which
capital structure decisions should be made.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 Factors that influence capital structure decisions…
m) Financial leverage/Financial risk
the use of long - term debt and preference share capital, which are fixed income-securities is
called financial leverage or trading on equity.
- the use of long-term debt capital increases the earnings per share (EPS) as long as the
return on investment (ROI) is greater than the cost of debt.
preference share capital will also result in increasing EPS but the leverage effect is more
pronounced in case of debt because: i) cost of debt is usually lower than the cost of
preference share capital, and ii) the interest paid on debt is tax deductible.
leverage is a two edged sword (needs caution) - producing highly favorable results when
things go well (i.e. the firm yields a return higher than the cost of debt), and quite the
opposite under unfavorable conditions (i.e. the rate of return on long-term loan is more
than the expected rate of earnings of the firm).
 Factors that influence capital structure decisions…
n) Operating leverage/business risk
- the single most important determinant of capital structure,
- other things the same, a firm with less operating leverage is better able to employ
financial leverage because it will have less business risk.
o) Other considerations
- Other factors such as nature of industry, timing of issue and competition in the industry
should also be considered. Industries facing sever competition also resort to more
equity than debt.
Hence, a finance manager in designing a suitable pattern of capital structure must bring
about satisfactory compromise among the foregoing factors. The compromise can be
reached by assigning weights to these factors in terms of various characteristic of the firm.
Leverage: Business Risk and Financial Risk

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 I. Leverage
 Leverage & Capital Structure
• a sound financial decision must consider the broad coverage of the financial
mix (capital structure), total amount of capital (capitalization) and cost of
capital.
• deciding the debt-equity mix plays a major role in the part of the value of the
company and market value of the shares.
• the debt equity mix of the company can be examined with the help of
leverage.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 I. Leverage
 Meaning of Leverage
• in general it refers to an increased means of accomplishing some purpose, e.g.
is used to lifting heavy objects, which may not be otherwise possible.
• in the financial point of view, leverage refers to furnish the ability to use fixed
cost assets or funds to increase the return to its shareholders (or lever up
profitability).

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 Leverage
• it refers to the use of special force and effects to produce more than normal results from
a given course of action..
• In business, leverage refers to the employment of fixed cost items in anticipation of
magnifying returns at high levels of operation.
• “the employment of an asset or fund for which the firm pays a fixed cost or fixed return –
(James Horne).
o Fixed costs that are operating costs (such as depreciation or rent) create operating
leverage….and fixed costs that are financial costs (such as interest expense) create
financial leverage.
 I. Leverage
 Importance of Leverage…
• a firm with higher fixed costs has greater leverage, and vice versa.
• magnifies/multiplies both returns and risks.
• a firm with more leverage may earn higher returns on average than a firm with less
leverage, but the returns on the more leveraged firm will also be more volatile/ you
should recognize that leverage is a two-edged sword—producing highly favorable
results when things go well and quite the opposite under negative conditions.
o Magnifies both returns and risks.
• influenced by managers choice of a specific capital structure.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 I. Leverage
 Types of Leverage
• Leverage can be classified into three major headings according to the nature
of the finance mix of the company.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 I. Leverage
 Fixed costs
- costs that do not rise and fall with changes in a firm’s sales.
- must be paid irrespective of whether business conditions are good or bad.
- may be operating costs, such as the costs incurred by purchasing and operating
plant and equipment, or they may be financial costs, such as the fixed costs of
making debt payments.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. Business Risk and Operating Leverage
1. Meaning of Business Risk
- is the risk a firm’s common stockholders would face if the firm had no debt or
is debt-free or unlevered.
- is the risk inherent in the firm’s operations, which arises from uncertainty
about future operating profits and capital requirements.
- depends on a number of factors, beginning with variability in product demand
and production costs.
- is the riskiness of the firm’s assets if no debt is used.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 II. Business Risk and Operating Leverage…
1. Meaning of Business Risk…
- the equity risk that comes from the nature of the firm’s operating activities.
- the variability of EBIT that has two components: variability of sales and
variability of expenses.
- operating risk is an unavoidable risk.
- the risk to the firm of being unable to cover its operating costs.
- in general, the greater the firm’s operating leverage—the use of fixed
operating costs—the higher its business risk.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 II. Business Risk and Operating Leverage…
2. Factors that affect Business Risk
a) Competition - other things held constant, less competition lowers business risk.
b) Demand variability - the more stable the demand for a firm’s products, other things
held constant, the lower its business risk.
c) Sales price variability - firms whose products are sold in volatile markets are exposed
to more business risk than firms whose output prices are stable, other things held
constant.
d) Input cost variability - firms whose input costs are uncertain have higher business
risk.
e) Product obsolescence - the faster its products become obsolete, the greater a firm’s
business risk.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. Business Risk and Operating Leverage…
2. Factors that affect Business Risk…
e) Foreign risk exposure - firms that generate a high percentage of their earnings
overseas are subject to earnings declines due to exchange rate fluctuations.
f) Regulatory risk and legal exposure - Firms that operate in highly regulated
industries such as financial services and utilities are subject to changes in the
regulatory environment that may have a profound effect on the company’s current
and future profitability.
g) Operating leverage (The extent to which costs are fixed) - if a high percentage of its
costs are fixed and thus do not decline when demand falls, this increases the firm’s
business risk.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. Business Risk and Operating Leverage…
3. Operating Leverage
- Indicates the extent to which fixed costs are used in a firm’s operations.
- Is the use of fixed operating costs to magnify the effects of changes in sales on
the firm’s earnings before interest and taxes (EBIT).
- when costs of operations are largely fixed, small changes in sales will lead to
much larger changes in EBIT.
- other things held constant, the higher a firm’s operating leverage, the higher its
business risk.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

II. Business Risk and Operating Leverage…
3. Operating Leverage…
- is associated with investment activities of the company.
- projects with a relatively heavy investment in plant and equipment will have
a relatively high degree of operating leverage.
- not affected by tax rate and interest rate.
- a high degree of operating leverage, other factors held constant, implies that a
relatively small change in sales results in a large change in return on invested
capital (ROIC).
 II. Business Risk and Operating Leverage…
3. Operating Leverage…
- is concerned with the relationship between the firm’s sales and its earnings
before interest and taxes (EBIT) or operating profits.
- when costs of operations (such as cost of goods sold and operating expenses)
are largely fixed, small changes in revenue will lead to much larger changes in
EBIT.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. Business Risk and Operating Leverage…
4. Measuring operating breakeven point
P = average sale price per unit;
Q = sales quantity in units;
FC = fixed operating cost per period;
VC = variable operating cost per unit
• where Q is the firm’s
operating breakeven point.
• Operating breakeven point
(in dollars - multiproduct
firms is: (NB. VC% total
sales)

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. Business Risk and Operating Leverage…
4. Measuring operating breakeven point…
- Firms use breakeven analysis, also called cost-volume-profit analysis, to
1) determine the level of operations necessary to cover all costs, and
2) evaluate the profitability associated with various levels of sales.
- The firm’s operating breakeven point is the level of sales necessary to cover
all operating costs. At that point, earnings before interest and taxes (EBIT)
equals zero.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. Business Risk and Operating Leverage…
4. Measuring operating breakeven point…
Example
Assume that ABC Co. has fixed operating costs of Birr2,500. Its sale price is
Birr10 per unit, and its variable operating cost is Birr5 per unit.
Q = Br2,500__ = 500 units
Br10 - Br5
At sales of 500 units, the firm’s EBIT should just equal Br0. The firm will have
positive EBIT for sales greater than 500 units and negative EBIT, or a loss, for
sales less than 500 units.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. Business Risk and Operating Leverage…
5. Measuring the Degree of Operating Leverage (DOL)
- the degree of operating leverage (DOL) is a numerical measure of the firm’s
operating leverage. It can be derived using the equation:
- %EBIT = %S * DOL

- a more direct formula for calculating the degree of operating leverage at a base
sales level, Q, is

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. Business Risk and Operating Leverage…
5. Measuring the Degree of Operating Leverage…
Example
Given the data for ABC Co. (sale price, P = Birr10 per unit; variable operating
cost, VC = Birr5 per unit; fixed operating cost, FC = Birr2,500) consider the
following two cases using the 1,000-unit sales level as a reference point:
Case 1 A 50% increase in sales (from 1,000 to 1,500 units) results in a 100%
increase in earnings before interest and taxes (from Birr2,500 to Birr5,000).
Case 2 A 50% decrease in sales (from 1,000 to 500 units) results in a 100%
decrease in earnings before interest and taxes (from Birr2,500 to Birr0).

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. Business Risk and Operating Leverage…
5. Measuring the Degree of Operating Leverage…

• Substituting Q = 1,000, P =
Birr10, VC = Birr5, and FC =
Birr2,500

 the DOL value of 2.0 means that

at ABC a change in sales volume
results in an EBIT change that is
twice as large in percentage
terms, e.g. a 50% change in sales would
lead to a 100% (50% * 2.0) change in EBIT.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 III. Financial Risk and Financial Leverage
1. Financial risk
- is the additional risk placed on the common stockholders as a result of
using debt or an increase in stockholders’ risk, over and above the firm’s
basic business risk, resulting from the use of financial leverage.
- is an avoidable risk if the firm decides not to use any debt in its capital
structure, i.e. a totally equity financed firm will have no financial risk.
- the variability of EPS caused by the use of financial leverage.
- the equity risk that comes from the financial policy (the capital structure)
of the firm.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 III. Financial Risk and Financial Leverage
2. Financial Leverage (Trading on Equity)
• is the use of fixed financial costs to magnify the effects of changes in earnings
before interest and taxes on the firm’s earnings per share, i.e. concerned with the
relationship between the firm’s EBIT and its common stock EPS.
• refers to the extent to which a firm relies on debt, i.e. the more debt financing
a firm uses in its capital structure, the more financial leverage it employs.
• the two most common fixed financial costs are
1) interest on debt and
2) preferred stock dividends.
• is associated with financing activities of the company.
• will change due to tax rate and interest rate.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 III. Financial Risk and Financial Leverage
3. Degree of Financial Leverage (DFL)- is the numerical measure of the firm’s
financial leverage.
- %EPS = %EBIT * DFL

- Whenever the percentage change in EPS resulting from a given percentage change
in EBIT is greater than the percentage change in EBIT, financial leverage exists. In
other words, whenever DFL is greater than 1, there is financial leverage.
- The effect of financial leverage is such that an increase in the firm’s EBIT results in a
more-than-proportional increase in the firm’s earnings per share, whereas a
decrease in the firm’s EBIT results in a more-than-proportional decrease in EPS.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 III. Financial Risk and Financial Leverage
• Example
XYZ Co. expects EBIT of Birr10,000 in the current year. It has a Birr20,000 bond
with a 10% (annual) coupon rate of interest and an issue of 600 shares of Birr4
(annual dividend per share) preferred stock outstanding. It also has 1,000 shares
of common stock outstanding. The annual interest on the bond issue is Birr2,000
(0.10 * Birr20,000). The annual dividends on the preferred stock are Birr2,400
(Birr4.00/share * 600 shares). Consider the following two situations:
Case 1 A 40% increase in EBIT (from Birr10,000 to Birr14,000) results in a 100%
increase in earnings per share (from Birr2.40 to Birr4.80).
Case 2 A 40% decrease in EBIT (from Birr10,000 to Birr6,000) results in a 100%
decrease in earnings per share (from Birr2.40 to Birr0).
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 III. Financial Risk and Financial Leverage

 These calculations show that when XYZ Co.'s EBIT changes, its EPS
changes 2.5 times as fast on a percentage basis due to the firm’s
financial leverage. The higher this value is, the greater the degree of
financial leverage.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 III. Financial Risk and Financial Leverage
• A more direct formula for calculating the degree of financial leverage at a base
level of EBIT is given by • Note that in the denominator the
term 1/(1 - T) converts the after-tax
preferred stock dividend to a before-
tax amount for consistency with the
• Example other terms in the equation.
Given: EBIT = Birr10,000, I = Birr2,000,
PD = Birr2,400, and the tax rate (T = 0.40)

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 IV. Relationship of Operating and Financial Leverage
 Total (or Combined) Leverage
- the use of fixed costs, both operating and financial, to magnify the effects
of changes in sales (Q) on the firm’s earnings per share (EPS).
- the total impact of the fixed costs in the firm’s operating and financial
structure.
- is the combined effect of operating and financial leverage.
- concerned with the relationship between the firm’s sales revenue and EPS.
 Relationship of Operating, Financial, and Total Leverage
- the relationship between operating leverage and financial leverage is
multiplicative rather than additive.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 IV. Relationship of Operating and Financial Leverage
 Relationship of Operating, Financial, and Total Leverage…
- the relationship between the degree of total leverage (DTL) and the
degrees of operating leverage (DOL) and financial leverage (DFL) is given
by:
- a more direct formula for calculating the degree of total leverage at a
given base level of sales, Q, is given by the following equation.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 IV. Relationship of Operating and Financial Leverage
 Relationship of Operating, Financial, and Total Leverage…
Example
Given Q = 20,000, P = $5, VC = $2, FC = $10,000, I = $20,000, PD = $12,000, and
the tax rate (T = 0.40) yields DTL at 20,000 units is:

= DTL = 1.2  5.0 = 6.0

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
IV. Relationship of Operating and Financial Leverage

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 Leverage - Synopsis
• “Leverage” is a general term that refers to an ability to multiply the effect of some effort. The term
comes from physics where a lever is used to multiply force. Financial leverage refers to using
borrowed money to multiply the effectiveness of the equity invested in a business enterprise.
• The borrowed money with which financial leverage is concerned is the debt in a company’s capital
structure. Hence, the terms “financial leverage” and “capital structure” are somewhat synonymous.
• To be leveraged means to have debt.
• To be unleveraged means to operate with only equity capital.
• In an unleveraged firm (one with no debt), the variation in ROE and EPS is identical
to the variation in EBIT.
• In a leveraged firm, the variation in ROE and EPS is always greater than the variation in EBIT.
 Leverage - Synopsis

• “Having a large amount of leverage is like driving a car with a dagger on the

steering wheel pointed at your heart. If you do that, you will be a better

driver. There will be fewer accidents but when they happen, they will be

fatal.” Warren Buffett

 Leverage - Synopsis
• The effects of financial and operating
leverage compound one another.
• Financial and operating leverage are similar in that both
can enhance results while increasing variation.
• A firm’s target capital structure is management’s estimate
of the optimal capital structure.
• Operating income (EBIT) is unaffected by financial
leverage.
• Under certain conditions, changing leverage increases
stock price. An optimal capital structure maximizes
stock price.
• Capital restructuring involves changing leverage by
shifting the mix of debt and equity
• Financial leverage refers to debt in the capital structure.
It multiplies the effectiveness of equity but adds risk.
Hand in Group Assignment
I

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

Exercise 1
Exercise 2
Exercise 3
Exercise 4
Determining the optimal capital structure

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

I. Definition of the Optimal Capital Structure

Capital Structure Decision

Designing an
Capital Structure Theories
Optimal Capital Structure

Modigliani- Miller (MM)

EBIT- EPS Analysis
theory
Trade-off theory
Signaling theory
… FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 I. Definition of the Optimal Capital Structure
• Definition
- an optimum capital structure may be defined as that combination of debt and
equity that maximizes the total value of the firm (V) or minimizes the
weighted average cost of capital (WACC).
- the value of the firm is maximized when the cost of capital is minimized, i.e. the
present value of future cash flows is at its highest when the discount rate (the
cost of capital) is at its lowest.
- the capital structure that maximizes a stock’s intrinsic value (the present value
of future cash flows).
- is the one that maximizes stock price, that generally calls for a Debt/Capital
ratio that is lower than the one that maximizes expected EPS.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 I. Definition of the Optimal Capital Structure
• Definition…
- a particular debt-equity ratio represents the optimal capital structure if it
results in the lowest possible WACC.
- this optimal capital structure is sometimes called the firm’s target capital
structure as well.
- many managers use the estimated relationship between capital structure and
the WACC to guide their capital structure decisions.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. EBIT/EPS analysis/approach to Capital Structure
 EBIT/EPS
- an approach for selecting the capital structure that maximizes earnings per
share (EPS) over the expected range of earnings before interest and taxes
(EBIT).
- is one important tool in the hands of the financial manager to get an insight
into the firm's capital structure planning. He can analyse the possible
fluctuations in EBIT and their impact on EPS under different financing plans.
- the firm should employ debt to such an extent that financial risk does not
spoil the leverage effect since under favourable conditions, financial leverage
increases EPS, however it can also increase financial risk to shareholders.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 II. EBIT/EPS analysis/approach to Capital Structure
 EBIT/EPS…
- the goal of the financial manager is to maximize owner wealth, that is, the
firm’s stock price. One of the widely followed variables affecting the firm’s
stock price is its earnings, which represents the returns earned on behalf of
owners.
- even though focusing on earnings ignores risk (the other key variable affecting
the firm’s stock price), earnings per share (EPS) can be conveniently used to
analyze alternative capital structures.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
 II. EBIT/EPS analysis/approach to Capital Structure
Example
ABC Company’s current capital structure is as follows:
Current capital structure
Long-term debt Br 0
Common stock equity (25,000 shares at Br20) 500,000
Total capital (assets) Br 500,000
Let us assume that the firm is considering three alternative capital structures. If we measure
these structures using the debt ratio, they are associated with ratios of 0%, 30%, and 60%.
Assuming that (1) the firm has no current liabilities, (2) its capital structure currently contains
all equity as shown, and (3) the total amount of capital remains constant at Br500,000.
Calculation of EPS for Selected Debt Ratios
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
II. EBIT/EPS analysis/approach to Capital Structure

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

II. EBIT/EPS analysis/approach to Capital Structure

Financial B/E point (X-axis

intercept) for:
DR of 0% = Br0
DR of 30% = Br15,000
DR of 60% = Br49,500

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. EBIT/EPS analysis/approach to Capital Structure
• An algebraic technique can be used to find the indifference points between
the capital structure alternatives.

Comparing ABC Company’s 0% and 30% capital structures, we get

 The calculated value

of the indifference
point between the
0% and 30% capital
structures is
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
therefore Br50,000.
 II. EBIT/EPS analysis/approach to Capital Structure
• Interpretation/Analysis
- ABC Co.’s capital structure alternatives plotted on the EBIT–EPS axes shows that each
capital structure is superior to the others in terms of maximizing EPS over certain
ranges of EBIT.
- Having no debt at all (debt ratio = 0%) is best for levels of EBIT between Br0 and
Br50,000. That conclusion makes sense because when business conditions are
relatively weak, ABC would have difficulty meeting its financial obligations if it had
any debt.
- Between Br50,000 and Br95,500 of EBIT, the capital structure associated with a debt
ratio of 30% produces higher EPS than either of the other two capital structures.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. EBIT/EPS analysis/approach to Capital Structure
• Interpretation/Analysis…
- When EBIT exceeds Br95,500, the 60% debt ratio capital structure provides the
highest earnings per share. Again, the intuition behind this result is fairly
straightforward. When business is booming, the best thing for shareholders is for
the firm to use a great deal of debt. The firm pays lenders a relatively low rate of
return, and the shareholders keep the rest.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. EBIT/EPS analysis/approach to Capital Structure
• Considering risk in EBIT–EPS analysis
- Graphically, the risk of each capital structure can be viewed in light of two
measures:
1. the financial breakeven point (EBIT-axis intercept) and
2. the degree of financial leverage reflected in the slope of the capital structure
line: the higher the financial breakeven point and the steeper the slope of
the capital structure line, the greater the financial risk.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. EBIT/EPS analysis/approach to Capital Structure
• Further assessment of risk can be performed by using ratios. As financial
leverage (measured by the debt ratio) increases, we expect a corresponding
decline in the firm’s ability to make scheduled interest payments (measured
by the times interest earned ratio).
• Reviewing the three capital structures plotted for ABC Co. we can see that as
the debt ratio increases, so does the financial risk of each alternative. Both
the financial breakeven point and the slope of the capital structure lines
increase with increasing debt ratios.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 II. EBIT/EPS analysis/approach to Capital Structure
• If we use the Br100,000 EBIT value, for example, the times interest earned
ratio (EBIT ÷ interest) for the zero-leverage capital structure is infinity
(Br100,000 ÷ Br0); for the 30% debt case, it is 6.67 (Br100,000 ÷ Br15,000);
and for the 60% debt case, it is 2.02 (Br100,000 ÷ Br49,500). Because lower
times interest earned ratios reflect higher risk, these ratios support the
conclusion that the risk of the capital structures increases with increasing
financial leverage. The capital structure for a debt ratio of 60% is riskier than
that for a debt ratio of 30%, which in turn is riskier than the capital structure
for a debt ratio of 0%.

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 III. The effect of capital structure on stock price and
the cost of capital
• Capital structure and Stock price
- Difficult to predict the effect of changes in capital structure on stock price.
- Capital structure that maximizes the stock price also minimizes the WACC.
• Capital structure and Cost of Capital
- Increases in the Debt/Capital ratio increases the costs of both debt and
equity. Hence,
- WACC = wd*(rd)*(1-T) + wc(rs); where wd and wc represent the percentage
of debt and equity in the firm’s capital structure that sum to 1.
- Bondholders recognize that if a firm has a higher Debt/Capital ratio, this
increases the risk of financial distress which leads to higher interest rates.
FM II Notes compiled by Andualem - 2015EC (2022/23 GC)
Introduction to Capital Structure Theories
&
Using debt financing to constrain managers

FM II Notes compiled by Andualem - 2015EC (2022/23 GC)

 Introduction
• Definition: Capital Structure is the mix of financial securities used to finance the
firm.
• Capital structure decision is a significant decision in financial management.
• Our goal is to see if there is an optimal way for firms to finance.
o Should a firm have a higher or lower D/E ratio.
o What factors affect the optimal D/E choice?
• The value of an enterprise depends on expected earnings and cost of capital.
• Capital structure may influences the value of the firm by operating on either
expected earnings or the cost of capital or both.
• In order to optimize the D/E ratio, our overall goal is to maximize the total value
of the firm and thus maximize expected shareholder wealth.
Capital Structure Theories
 The Net Income Approach
•
The Net Income Approach…
 The Net Operating Income Approach
• Contends that the capital structure does not matter, and
• that the firm cannot affect its overall cost of capital through leverage.
• Overall cost of capital remains constant.
• As more debt is incurred, equity investors, in order to compensate for the increased
financial risk, increase their capitalization rate of earnings in such a way as to cancel out
the benefit derived from the use of debt, and the average cost remains unchanged.
• Thus, there is no single point or range where the capital structure is optimum.
 The Net Operating Income
Approach…
Using an equation

• The critical premise of this approach is that the market capitalises the firm as a whole at
a discount rate which is independent of the firm’s debt-equity ratio.
• As a consequence, the division between debt and equity is irrelevant.
• An increase in the use of debt funds which are ‘apparently cheaper’ is offset by an
increase in the equity capitalization rate.
The Net Operating Income
Approach…

Where rA is the overall cost of capital.

 Traditional Approach
• The traditional approach is midway between the NI and NOI approaches
• The crux of the traditional view relating to leverage and valuation is that
• through judicious use of "debt to equity proportions", a firm can increase its total
value and thereby reduce its overall cost of capital.
• Rationale:
• that debt is a relatively cheaper source of fund as compared to ordinary shares.
• By using more debt in the place of equity, a cheaper source of fund replaces a
source of fund which involves, by comparison, a higher cost.
• However, beyond a certain level of leverage, investors may perceive a high
degree of financial risk and this increases equity and debt capitalization rates.
 Traditional Approach…
• The impact of leverage on cost of capital and value of the firm can be studied in
three distinct stages (Solomon Ezra, 1963).
• Stage 1: cost of equity rises as debt is added but does not increase fast enough
to offset the advantage of low cost debt ; cost of debt remains constant or rises
modestly.
o the value of the firm increases or the overall cost of capital falls with increasing leverage.
• Stage 2: the addition of debt, after a certain degree of leverage has been
reached, provides only a moderate increase in market value.
o As a consequence cost of capital remains relatively constant
• Stage 3: beyond the acceptable limit of leverage, the value of the firm decreases
or the cost of capital increases with the leverage.
 Modigliani - Miller Approach
• Modern capital structure theory began in 1958 with Professors Franco
Modigliani and Merton Miller (hereafter, MM).
• Suggest that it does not matter how a firm finances its operations,
hence capital structure is irrelevant.
Modigliani - Miller Approach…
• MM approach provides behavioural justification for constant overall cost of
capital and, therefore, total value of the firm.

MM Approach – 1958: without tax

• MM Approach
MM Approach – 1963: with tax
 MM Approach – 1958: without tax
• M&M began looking at capital structure in a very simplified world
so that we would know what does or does not matter.
• Assumptions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future
investment opportunities.
6. EBIT is not affected by the use of debt.
 M&M No Tax: Result
• A change in capital structure does not matter to the overall value of the firm.
The total cash flows produced are the same, thus the total value of the cash
flows is the same.
• It doesn’t matter if the cash flows from the firm to its security holders are
called debt or equity cash flows.
 The M&M Propositions I (No Taxes)
• Firm value is not affected by leverage.
o VL = VU
• The derivation is straightforward
• Shareholders in a levered firm receive Bondholders receive
o EBIT − rBB rBB
• Thus, the total cash flow to all stakeholders is:
o (EBIT − rBB) + rBB
• The present value of this stream of cash flows is VL
o (EBIT − rBB) + rBB = EBIT
• The present value of this stream of cash flows is VU
∴VL = VU
 The M&M Propositions I (No Taxes)…
- Intuition: Through homemade leverage/arbitrage process, individuals can either
duplicate or undo the effects of corporate leverage.
- for the firms in the same risk class, the total market value is independent of capital
structure and is determined by capitalising net operating income by the rate appropriate
to that risk class.
- the average cost of capital is not affected (i.e. constant) by degree of leverage and is
determined as follows:
- MV of Firm (V) = MV of Equity (S) + MV of Debt (D) = Net Operating Income (NOI)/K 0
- K0 = Cost of capital = NOI/V
 The M&M Propositions I (No Taxes)…
- Arbitrage process - if levered firms are priced too high, rational investors will arbitrage
by borrowing on their personal accounts to buy shares in unlevered firms. This
substitution is often called homemade leverage; or investors replicate the firm’s
proposed capital structure or debt-equity ratio (i.e. at company level) at the personal
level.
- Because of this arbitrage process, the market price of securities in higher valued
market will come down and the market price of securities in the lower valued market
will go up, and this switching process is continued until the equilibrium is established
in the market values.
 The M&M Propositions I (No Taxes)…
- view the capital structure question in terms of a “pie” model,
- i.e. given for two firms with identical on the left side of the balance sheet (i.e. their assets and
operations are exactly the same); the right sides are different because the two firms finance their
operations differently; the size of the pie is the same for both firms because the value of the assets is
the same;
- thus the size of the pie doesn’t depend on how it is sliced.
 The M&M Propositions II (No Taxes)
• Leverage increases the risk and return to stockholders.
• The use of supposedly “cheaper” debt funds is offset exactly by the increase
in the required equity return, rS.
• rS = r0 + (B/S) (r0 - rB)
• rB is the interest rate (cost of debt)
• rs is the return on (levered) equity (cost of equity)
• r0 is the return on unlevered equity (cost of capital)
• B is the value of debt
• S is the value of levered equity
 The M&M Propositions II (No Taxes)
…
•
 The M&M Propositions II (No Taxes)
…
- Intuition: The cost of equity rises with leverage, because the risk to
equity rises with leverage. (required return/risk to equity holders rises with
leverage).
- Although changing the capital structure of the firm does not change the firm’s total
value, it does cause important changes in the firm’s debt and equity.
- Proposes that a firm’s cost of equity capital is a positive linear function of the firm’s
capital structure.
 The M&M Propositions II (No Taxes)…
Graphically
 The M&M Propositions II (No Taxes)…Example
- A Co. has a weighted average cost of capital (ignoring taxes) of 12%. It can
borrow at 8%. Assuming that the Co. has a target capital structure of 80%
equity and 20% debt, what is its cost of equity? What is the cost of equity if the
target capital structure is 50% equity? Calculate the WACC using your answers
to verify that it is the same.
- The cost of equity, RE = RA + (RA − RD ) × (D / E ) MM II
- Case -1: the debt-equity ratio is .2/.8 = .25, so the cost of the equity is 13%.
RE = .12 + (.12 − .08) × .25 = .13, or 13%.
 The M&M Propositions II (No Taxes)…
Example
- Case – 2: the debt-equity ratio is 1.0, so the cost of equity is 16%.
RE = .12 + (.12 − .08) × 1.0 = .16, or 16%.
- The WACC
- Case – 1: assuming that the percentage of equity financing is 80%, the cost of
equity is 13%, and the tax rate is zero:
WACC = (E / V) × RE + (D / V) × RD = .80 × .13 + .20 × .08 = .12, or 12%
- Case – 2: assuming that the percentage of equity financing is 50% and the cost of
equity is 16%.
WACC = (E / V) × RE + (D / V) × RD = .50 × .16 + .50 × .08 = .12, or 12%
- As calculated, the WACC is 12% in both cases.
 M&M with Corporate Taxes
• When corporate taxes are introduced, then debt financing causes a positive
benefit to the value of the firm.
• The reason for this is that debt interest payments reduce taxable income and
thus reduce taxes.
o Thus with debt, there is more after-tax cash flow available to security holders (equity
and debt) than there is without debt.
o Thus the value of the equity and debt securities combined is greater.
 M&M Proposition I (with Corporate
Taxes)
• Firm value increases with leverage
VL = V U + T B
o where T is the corporate tax rate and B is the amount of debt.
• Shareholders in a levered firm receive Bondholders receive
o (EBIT − rBB) x(1-T) r BB
• Thus, the total cash flow to all stakeholders is:
o (EBIT − rBB) x (1-T) + rBB= EBIT x (1-T)− rBB + rBB T + rBB
= EBIT x (1-T) + rBBT
• The present value of this stream of cash flows is V L
o EBIT x (1-T)
• The present value of this stream of cash flows is V U
∴VL = VU + T B
• Note that the present value of rBBT is BT.
 M&M Proposition I (with Corporate
Taxes)…
- Implications of Proposition I:
1) Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure
is 100 percent debt.
2) A firm’s weighted average cost of capital (WACC) decreases as the firm relies more heavily
on debt financing.
- Example:
- EBIT is expected to be Br1,000 every year forever for both firms (L & U).
- Firm L has issued Br1,000 worth of perpetual bonds with 8% interest each year
(i.e. pays Br80 interest every year forever). The tax rate is 21%.
 M&M Proposition I (with Corporate
Taxes)…
- the net income for firms U & L is:

- the cash flow from assets is equal to EBIT – Taxes assuming that depreciation
is zero; capital spending is zero and that there are no changes in NWC for
firms U and L:
 M&M Proposition I (with Corporate
Taxes)…
- the cash flow to stockholders and bondholders is:

- Firm L has Br16.80 more total cash flow due to the tax savings/ the interest tax
shield = Br80 × .21 = Br16.80.
 M&M Proposition I (with Corporate
Taxes)…
- Present value of the interest tax shield = (T × B × rB) / rB = T × B
- the present value (PV) of the tax shield is: PV = Br16.80/.08 = (.21 × Br1,000
× .08)/.08 = .21 × Br1,000 = Br210.
- because the tax shield is generated by paying interest, it has the same risk as the
debt, and 8% (the cost of debt) is the appropriate discount rate.
- VL = VU + TC × D. if the cost of capital for Firm U is 10%, then

- VU = (EBIT × (1 − T))/RU = Br790/.10 = Br7,900

- VL = VU + T × B = Br7,900 + .21 × 1,000 = Br8,110
 M&M Proposition II (with Corp. Taxes)
- This proposition is similar to Prop. II in the no tax case, however, now the risk and return
of equity does not rise as quickly as the debt/equity ratio is increased because low-risk
tax cash flows are saved.
- Some of the increase in equity risk and return is offset by interest tax shield.
- The cost of equity, rS, is: rS = r0 + (B/S) (r0 - rB) × (1 − T)

- Where:
• rB is the interest rate (cost of debt)
• rs is the return on (levered) equity (cost of equity)
• r0 is the return on unlevered equity (cost of capital)
• B is the value of debt
• S is the value of levered equity
• T is corporate tax rate
 M&M Proposition II (with Corp.
Taxes)…
- Unlike the case with Proposition I, the general implications of Proposition II are the
same whether or not there are taxes.
- Given the following information for the Format Co.:
- EBIT = Br 126.58; T = .21; B = Br500; r0 = .20; The cost of debt capital is 10%.
1. What is the value of Format’s equity?
2. What is the cost of equity capital for Format?
3. What is the WACC?
 M&M Proposition II (with Corp. Taxes)
…
1) Ve is:
Vf without debt: VU = (EBIT − Taxes)/RU = (EBIT × (1 − T))/RU = Br100/.20= Br500
Vf with debt (from MM Proposition I with taxes): VL = VU + T × B= Br500 + (.21 × Br500)= Br605
Ve = VL − B= Br605 − Br500= Br105.
2) Cost of equity (rS) is:
rS (MM Proposition II with taxes) = r0 + ( r0 − rB) × (B / S) × (1 − T)
= .20 + (.20 − .10) × (500 / 105) × (1 − .21)
= .5762, or 57.62%
3) WACC is:
WACC = (105 /605) × .5762 + (500 /605) × .10 × (1 − .21) = .1653, or 16.53%
 Hence, this is lower than the cost of capital for the firm with no debt (r0 = 20%), so
debt financing is advantageous.
M&M Proposition II (with Corp.
Taxes)…
 Other Capital Structure Theories
• So far we have examined capital structure without and with corporate taxes.
Our conclusions have been that capital structure does not matter to the value
of the firm (no-tax case) or the optimal capital structure is 100% debt.
• In this section we shall examine other factors that affect the optimal capital
structure.
o Cost of financial distress
o Agency costs of equity
o costs of external financing
o Signaling
• The end result is an intermediate capital structure that depends on firm-
specific characteristics.
 Trade-off theory
- The capital structure theory that states that firms trade off the tax benefits of debt
financing against problems caused by potential bankruptcy.
- As the debt level increases, the value of the expected tax shields from debt
increases; however so does the value lost due to the expected financial
distress costs.
- At some point, the marginal benefit from interest tax shields is just offset by
the marginal cost of more expected financial distress costs.
- This leads to a limit on the optimal amount of debt in the firm’s capital
structure.
 Trade-off theory…
• what are costs of financial distress?
o refers to the additional expenses that a firm in financial distress incurs
beyond the cost of doing business.
o Direct costs – legal and admin costs e.g Bankruptcy filing fees.
o Indirect costs
Losses of customers, suppliers, good employees, etc.
Agency costs of debt
 Incentive to take large risks (even if assets are redeployed to negative NPV projects).
 Incentive to milk the property
 Incentive toward underinvestment
 Trade-off theory…

Value of the firm with financial distress:

• VL= VU +T●B–PV expected financial distress
• The value of the levered firm is reduced by the present value of the expected
financial distress.
Integration of Tax Effects and Financial Distress Costs
 Agency Costs of Equity
• The more discretionary cash flow management controls, the more it will be
tempted to spend money on perquisites or to shirk in its duties.
• Higher debt levels reduce discretionary cash flows controlled by management,
and therefore reduce the waste caused by management shirking or spending
on perquisites.
• Thus higher debt levels add to firm value.
• Value of the firm with agency costs of equity (or agency costs of free cash
flow):
• VL= VU +T●B – PV expected financial distress + PV savings of shirking and perquisites costs
 Agency Costs of Equity…
• The value of the levered firm is reduced by the present value of the expected
financial distress costs.
• However, now it is increased as debt increases because of the savings of the
agency costs of equity.
• Save costs related to excessive perquisites or shirking of management.
 Pecking Order Theory
• Suggests that firms prefer to finance their investment projects internally using
retained earnings before issuing debt or equity.
• The theory is based on the assumption that internal funds are the cheapest
and least costly form of financing, followed by debt, and then equity.
• The firms want to avoid the costs associated with external financing, such as
underwriting fees, interest payments, and dilution of ownership.
 Pecking Order Theory…
Reasons why firms may prefer to use internal funds to finance their investment
projects:
a. internal funds are typically the most readily available form of financing.
b. internal funds do not have to be repaid, unlike debt, and they do not dilute ownership,
unlike equity.
c. internal funds can be used to finance investment projects without having to disclose
information about the projects to investors, which can be advantageous in some cases.

∴ The Pecking Order Theory thus states that managers will finance first with
retained earnings, then debt, and finally additional equity issue.
 Signaling theory
- Information asymmetry - The situation where managers have different (better)
information about firms’ prospects than do investors, contrary to MM assumption
of information symmetry.
- Signal - An action taken by a firm’s management that provides clues to investors
about how management views the firm’s prospects.
- a firm with very favorable prospects would be expected to avoid selling stock and
instead raise any required new capital by using new debt, even if this moved its
debt ratio beyond the target level.
- a firm with unfavorable prospects would want to finance with stock, which would
mean bringing in new investors to share the losses.
- the announcement of a stock offering is generally taken as a signal that the firm’s
prospects as seen by its management are not bright.
 Signaling theory…

• Because management knows more about the true value of the firm, investors
will interpret an equity issue to signal management’s assessment that the
firm’s equity value must be overvalued.
• Debt has contractual payments, thus there is less of an over-valued signal
when debt is issued. In fact, debt can signal that management is confident in
its firm and believes servicing the debt will not be a problem.
Signaling theory…
Result: markets react very negatively to additional equity issues, less negatively to additional
debt issues:
- Issuing stock emits a negative signal and thus tends to depress the stock price; even
if the company’s prospects are bright.
∴ a firm should, in normal times, maintain a reserve borrowing capacity that can be used in the
event that some especially good investment opportunity comes along.
- This means that firms should, in normal times, use more equity and less debt than is
suggested by the tax benefit/bankruptcy cost trade-off model.
- Firms often use less debt than specified by the MM optimal capital structure in
“normal” times to ensure that they can obtain debt capital later if necessary.
 Exercise
• What is the optimal capital structure?
• What is the value of the firm under the optimal capital structure?
• What is the value of the firm’s debt and its equity under the optimal capital
structure?