Chapter Five: Financing Decision: Gedewon Gebre (MSC Accounting and Finance, Certified Authorized Accountant-Ethiopia)

INFO LINK UNIVERSITY COLLEGE HAWSSA ACFN FM –I FOR 3r d year (R, W & E)
CHAPTER FIVE: FINANCING DECISION

Introduction
A firm’s capital structure is the specific combination of long-term debt and equity the firm uses
to finance its operations.”. In other words, it represents the mix of different sources of long-term
funds (such as Common Stocks, Preference Stocks, Long-terms Bonds and Retained Earnings,
etc.) in the total capitalization of the company. For example, a company has Common Stocks of
Birr.100, 000, Preference Stocks of Birr.100, 000, Long-term Bonds Birr.100, 000 and retained
Earnings of Birr.50, 000. The term capital structure is used for total long-terms funds. In this
case it is ofBirr.350, 000. In this case it will be said that the capital structure of the company
consist of Birr.100, 000 in common stocks,Birr.100,000 in preference stocks, Birr.100,000 long-
term bonds and Birr.50,000 retained earnings. Sometimes people confused with term
CapitalStructure and Financial Structure: But, the term capital structure differs from financial
structure. Financial Structure refer to the way of firm’s assets are financed. In other words, it
includes both, long-term as well as short-term sources of funds. Capital structure is the
permanent financing of the company represented primarily by long-term bonds and stockholders
funds but excluding all short-term credit. Thus, a company’s capital structure is only a part of its
financial structure.
5.1. The concept of capital structure (Debt vs. Equity capital)
If it is to grow, a firm needs capital, and that capital can come in the form of debt or equity. Debt
financing has two important advantages: (1) Interest paid on debt is tax deductible, (2) the return
on debt is fixed, and mandatory for payment regardless the profitability of the company.
However, debt also has disadvantages: (1) Using more debt increases the firm’s risk, which
raises the costs of both debt and equity. (2) If the company falls on hard times and its operating
income is not sufficient to cover interest charges, the stockholders will have to make up the
shortfall; if they cannot, the firm will go bankrupt. Good times may be just around the corner, but
too much debt can keep the company from getting there and thus can wipe out the stockholders’
equity. Because of these factors, companies with volatile earnings and operating cash flows tend
to limit their use of debt. On the other hand, companies with less business risk and more stable
operating cash flows can take on more debt. On other hand using equity (common stock) for
financing has two advantage such as 1) shareholders has ownership right and remain silent till
BOD declare dividend 2) right to share profit but not mandatory like that of debt i.e. it is based
on profitability of the firm (stockholders do not have to share the firm’s profits if it is not
extremely successful). However equity has its own drawbacks such as 1) dividends paid on stock
are not tax deductible 2) there is the dilution of control in ownership. With regarding to preferred
stock it has hybrid characteristics as debt – its dividend is fixed but not tax deductible. Like
common stock dividend payment is not mandatory but prior to common stock dividend and also
cumulative is some cases. Therefore by taking in to account these factorsthe firm should
structure its capital.
Target Capital Structure: The mix of debt, common stock & preferred stock with which the
firm plans to raise capital.
Optimal Capital Structure: The firm’s capital structure that maximizes the shareholders’ value
(stock price). A firm should try to maintain an optimum capital structure with a view to maintain
financial stability. The optimum capital structure is obtained when the market value per equity
share is the maximum. It may, therefore, be define as the relationship of debt and equity
securities maximizes the value of a company’s share in the stock exchange. In case a company
borrows and this borrowing helps in increasing the value of the company’s share in the stock
1 Financial Decision (Chapter Five) compiled by : Instructors: Gedewon Gebre (Msc Accounting and Finance,
Certified Authorized Accountant- Ethiopia) October, 2021
exchange, it can be said that the borrowing has helped the company in moving towards its
optimum capital structure. In case, the borrowing results in fall the market value of the
company’s equity shares, it can be said that the borrowing has moved the company away from its
optimum capital structure.
Features of an Optimum/Appropriate Capital Structure:
A capital structure will be considered to be appropriate if it possesses following features:
Profitability: The capital structure of the company should be most of profitable. The
most profitable capital structure is one that tends to minimize cost of financing and
maximize earning per equity share.
Solvency: The pattern of capital structure should be so devised as to ensure that the firm
does not run the risk of becoming insolvent. Excess use of debt threatens the solvency of
the company. The debt content should not, therefore, be such that it is increases risk
beyond manageable limits.
Flexibility: The capital structure should be such that is can be easily maneuvered. To
meet the requirements of changing conditions. Moreover, it should also be possible for
the company to provide funds whenever needed to finance its profitable activities.
Conservatism: The capital structure should be conservative in the sense that the debt
content in the total structure does not exceed the limit which the company can bear. In
other words, it should be such as is commensurate with the company’s ability to generate
future cash flows.
Control: The capital structure be so devised that it involves minimum risk of loss of
control of the company.
At optimum capital structure, the average cost of capital is the minimum. In order to optimize its
capital the firm should answer the question: What is the optimal debt-equity ratio? It needs to
consider two kinds of risk:
A. Business risk
B. Financial risk
A) Business risk: What is business risk? It can be defined as uncertainty about future
pre-tax operating income (EBIT). The riskiness inherent in the firm’s operations if it
uses no debt.
Graphically:
Fig 5.1. The relationship between EBIT and business risk

Note that business risk focuses on operating income, so it ignores financing effects.
Example of Business Risk: Suppose 10 people decide to form a corporation to manufacture disk
drives, if the firm is capitalized only with common stock – and if each person buys 10% -- each
investor shares equally in business risk. In other way if the same firm is now capitalized with
50% debt and 50% equity – with five people investing in debt and five investing in equity, The 5
who put up the equity will have to bear all the business risk, so the common stock will be twice
as risky as it would have been had the firm been all-equity (unlevered).
Factors That Influence Business Risk: Business risk depends on a number of factors, the more
important of which are listed below:
1. Demand variability. The more stable the demand for a firm’s products, other things held
constant, the lower its business risk.
2. Sales price variability. Firms whose products are sold in highly volatile markets are exposed
to more business risk than similar firms whose output prices are more stable.
3. Input cost variability. Firms whose input costs are highly uncertain are exposed to a high
degree of business risk.
4. Ability to adjust output prices for changes in input costs. Some firms are better able than
others to raise their own output prices when input costs rise. The greater the ability to adjust
output prices to reflect cost conditions, the lower the degree of business risk.
5. Ability to develop new products in a timely, cost-effective manner. Firms in such high-tech
industries as drugs and computers depend on a constant stream of new products. The faster its
products become obsolete, the greater a firm’s business risks.
6. Foreign risk exposure. Firms that generate a high percentage of their earnings overseas are
subject to earnings declines due to exchange rate fluctuations. Also, if a firm operates in a
politically unstable area, it may be subject to political risks. See Chapter 16 for a further
discussion.
7. The extent to which costs are fixed: operating leverage. If a high percentage of costs are
fixed, hence do not decline when demand falls, then the firm is exposed to a relatively high
degree of business risk. This factor is called operating leverage, and it is discussed at length in
the next section.
B) Financial Risk: The additional risk placed on the common stockholders as a result of the
decision to finance with debt. Financial leverage concentrates the firm’s business risk on the
shareholders because debt-holders, who receive fixed interest payments, bear none of the
business risk.
5.2. Leverage
I Will Start My Class with a Question i.e. what is Leverage? Can you tell me what it is?
Meaning of Leverage:
In physics, leverage implies the use of a lever to raise a heavy object with a small force. In
politics, if people have leverage, their smallest word or action can accomplish a lot. However, in
the area of finance, the term leverage has a special meaning. It is used to describe the firm’s
ability to use fixed cost assets or funds to magnify the return to its owners. On other hand, a high
degree of operating leverage, other factors held constant, implies that a relatively small change in
sales results in a large change in EBIT. When the volume of sales changes in small, the volume
of profit highly changes & leverage helps in quantifying such influence. It may, therefore, be
defined as relative change in profits due to a change in sales. A high degree of leverage implies
that there will be a large change in profits due to relatively small change in sales and vice versa.
Thus, higher is the leverage, higher is the risk and higher is the expected return.
Types of Leverages:
Leverages are of three types:
(A) Operating Leverage
(B) Financial Leverage, and
(C) Composite Leverage / Combined Leverage/
(A) Operating Leverage:
The operating leverage may be defined as the tendency of the operating profit to vary of
disproportionately with sales. It is said to exist when a firm has to pay fixed cost regardless of
volume of output or sales. The firm is said to have a high degree of operating leverage if it
employs a greater amount of fixed costs and a small amount of variable costs. One the other
hand, a firm will have a low operating leverage when it employs a greater amount of variable
costs and a smaller amount of fixed costs. In business terminology, a high degree of operating
leverage, other factors held constant, implies that a relatively small change in sales results in a
large change in EBIT.
Formula: The Operating Leverage can be calculated by the following formula:

Contribution
Operating Leverage = ------------------
EBIT
Notes: 1. Contribution = Net Sales – Variable Cost (OR)
Contribution = Fixed Cost + EBIT
2. EBIT = Net Sales – Variable Cost – Fixed Cost (OR)
EBIT = Contribution – Fixed Cost
3. EBIT can also be called as Operating Profit.
4. EBIT means “Earnings before Interest and Tax”
5. Higher the Operating Leverage = Higher the Risk
Lower the Operating Leverage = Lower the Risk
6. Operating Leverage may be Favourable or Unfavourable.
If Contribution exceed the fixed cost – Favourable
If Contribution not exceed the fixed cost – Unfavorable
ON Income Statement:
Sales………………………Birr XX
Less: Variable Cost (xx)
Contribution XX
Less: Fixed Cost (xx)
EBIT (Operating Profit)Xx
Less: Interest on Bonds (xx)
EBT XX
Less: Taxes (30%) (xx)
EATXX
Less: Preference Stock Dividend (xx)
Earning available to common Stock holders XX
Divided bycommon stock outstanding… ……XX
= EPS………………………………………BirrXX
Earnings available to Common Stock holders
Earnings per Share (EPS) = -----------------------------------------------------
No. of Outstanding Common Stocks
Degree of Operating Leverage (DOL):

Degree of operating leverage (DOL) measures the responsiveness of operating income (EBIT) to
change in the level of sales and gives management an indication of the response in profits it can
expect if the level of sales is altered. If a firm has a high degree of operating leverage, small
changes in sales will have largeeffects on operating income. In other words, the operating profits
(EBIT) of such a firmwill increase at a faster rate than the increase in sales. Similarly, the
operating profits of such a firm will suffer a greater loss as compared to small reduction in its
sales.This is calculated using the following formula:
Example 5.2: Suppose XY Corporation has 10,000 common stock outstanding, sold its products
at sales levels of 6,000 and 8,000 units with fixed costs is Birr.100, 000, each unit was sold for
Birr.43.75 Variable costs are Birr.18.75 per unit. Determine operating and degree of operating
leverage of the firm? With 30% tax and Ignore interest expense
Solution
 First calculate EBIT under two cases
At, 8,000 quintal
Sales………………………Birr350, 000
At, 6,000 quintals
Sales………………………Birr 262,500 Less: Less: Variable Cost (150,000)
Variable Cost (112,500) Contribution margin 200,000
Contribution margin 150,000 Less: Fixed Cost (100,000)
Less: Fixed Cost (100,000) EBIT Birr.100, 000
EBIT (Operating Profit) Birr50, 000 Interest ……………………………10,000
Interest…………………………10,000 EBT…………………………………90,000
EBT…………………………….40, 000 Tax (0.3*90,000)…………………. (27,000)
Tax (0.3*40,000)……………… 12,000 EAT (net profit)…………………. Birr 63, 000
EAT ……………………………Birr 28, 000 EPS……………………………….Birr.6.3
EPS…… … (28,000/10,000)……Birr.2.8
CM 150,000 CM 200,000
 OL @ 600= = =3  OL @ 8000= = =2
EBIT 50 ,000 EBIT 100,000
%EBIT 1.00
 DOL= = =3
%Sales 0.33 '
Interpretation:(1) Operating leverage may be favorable or unfavorable. In our given example

above the OL of the XY corporation is favorable at both sales levels of 6,000 and 8,000 units
since the contribution (i.e., sales less variable cost) exceeds the fixed cost.
(2) The above computations of DOL also indicate that a 1% change in sales will produce a 3%
change in EBIT. Or if sales increase 5%, a DOL of 3.0 indicates that EBIT would increase 15%.
On the other hand, if sales decline by 7%, a DOL of 3.0 indicates that EBIT would decline 21%.
B) Financial leverage:
Financial leverage is use of fund with fixed cost in order to increase earnings per share (EPS). It
can be alsodefined as the tendency of the residual net income to vary disproportionately with
operating profit. It indicates the change that takes place in the taxable income as a result of
change in the operating income. It signifies the existence of fixed interest/fixed dividend bearing
securities such as bonds and preferred stock along with the common equity in the total capital
structure of the company, is described as financial leverage. Where in the capital structure of the
company, the fixed interest/dividend bearing securities are greater as compared to the equity
capital, the leverage is said to be larger. In a reverse case the leverage will be said to be smaller.
Degree of Financial Leverage (DFL):
Degree of financial leverage is defined as the percentage change in the EPS resulting from a
percentage change in EBIT. This can be calculated using the following formula:
Example 5.3: In the foregoing example the FL and DFL can be computed as follow: in our
example there is preferred capital, hence FL and DFL of the firm at both sale levels were
calculated as:
EBIT 50,000 EBIT 100,000

 FL @ 600= = =1.25∧FL@8000= = =1.11
EBT 40 , 000 EBT 90,000

% Change∈ EPS 1.25 6.3−2.8 100,000−5
DFL= = =1.25 where % Change∈EPS= =1.25∧% change∈ EBIT
% change ∈EBIT 1 2.8 50,00
Interpretation: (1) Financial leverage may be favorable or unfavorable. In our example the FL of
the XY Corporation is favorable at both sales levels of 6,000 and 8,000 units since the EBIT (i.e.,
EBIT less financing cost) exceeds the interest.
(2) 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. Accordingly, the above
computations of DFL of XY Corporation also indicate that a 1% change in EPS will produce a
1.25% change in EBIT. Or if EPS increase 5%, a DFL of 1.25 indicates that EBIT would
increase 6.25%. On the other hand, if EPS decline by 4%, a DFL of 1.25 indicates that EBIT
would decline 5%.
(C) Composite Leverage / Combined Leverage

Operating leverage measures percentage change in operating profit (EBIT) due to percentage
change in sales. It explains the degree of operating risk. Financial leverage measures percentage
change in earnings per share (EPS) on account of percentage change in operating profit (EBIT).
Thus, it explains the degree of financial risk. Both these leverages are closely concerned with
the firm’s capacity to meet its fixed costs (both operating and financial). In case both the
leverages are combined, the result obtained will disclose the effect of change in sales over
change in earnings per share (EPS). Composite leverage thus expresses the relations between
revenue on accounts of sales (i.e. contribution) and the Earnings per share (EPS). It helps in
finding out the resulting percentage change in EPS on account of percentage change in sales.
This can be computer as follows.
Composite Leverage (CL) = Operating Leverage X Financial Leverage
CL@6000 units = OL X FL = 3.0*1.25= 3.75 or contribution margin/EBT =150,000/40,000=3.75
Degree of Composite Leverage (DCL):

Degree of composite leverage is defined as the percentage change in the EPS resulting from a
percentage change in Sales. It is the Potential use of fixed costs, both operating and financial,
which magnifies the effect of sales volumeon the earning per share of the firm.A high degree of
operating leverage together with a high degree of financial leverage makes the position of the
firm very risky. This is because on the one hand it isemploying excessively assets for which it
has to pay fixed costs and at the same time itis also using a large amount of debt capital. The
fixed costs towards using assets andfixed interest charges bring a greater risk to the firm. In case
the earnings fall, the firm may not be in a position to meet its fixed costs. This is calculated using the
following formula:
DCL = DOL X DFL
(OR) % Change in EBIT % Change in EPS
Degree of Composite Leverage = -------------------------- X ---------------------------
% Change in Sales % Change in EBIT
Therefore,
% Change in EPS
Degree of Composite Leverage = ------------------------
% Change in Sales
Higher the Composite Leverage = Higher the overall Risk

Lower the Composite Leverage = Lower the overall Risk
Exercise 5.4: From the above illustration we can calculate theDCL &Interpret your results?
Solution
In our example we have actually calculated DOL, DFL, % Change in EPS&% Change in Sales
therefore, DCL is 3*1.25 = 3.75 or 1.25/0.33’ = 3.75
Interpretation:Note: If Fixed = 0, and Interest = 0, DCL = 1.0 (i.e., without Fixed cost or
Interest the % change in EPS would be equal to the % change in sales). By employing Fixed cost
or Interest (or both), the firm’s % change in EPS will be greater than the % change in sales.
Accordingly, in our illustration of XY corporation 1% change in EPS resulted in 3.75% change
in sale.
5.3. Overview of breakeven point

Breakeven analysis, sometimes called cost-volume-profit analysis, is used by the firm (1) to determine
the level of operations necessary to cover all operating costs and (2) to 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 equal Br.0 on other
handit is the point at which sales volume required so that total revenues and total costs are equal; may be
in units or in sales Birrs.
How to find the quantity break-even point? BEP in quantity (unit) can be determined as
EBIT = P (Q) – V (Q) – FC
EBIT = Q (P – V) – FC
P = Price per unit V = Variable costs per unit
FC = Fixed costs Q = Quantity (units) produced and sold
Breakeven point occurs when EBIT = 0
Q (P – V) – FC = EBIT
QBE (P – V) – FC = 0
QBE (P – V) = FC i.e. BEP occurs when contribution margin is equal to fixed cost.
QBE = FC / (P – V)
How to find the quantity break-even point in sales? BEP in sales (Birr) can be determined as:
To find the sales break-even point:

SBE = FC + (VCBE)
SBE = FC + (QBE) (V) or
SBE* = FC / [1 – (VC / S)]
Example 4.6:XY Corporation wants to determine both the quantity and sales break-even points
of units sold when:Fixed costs are Birr.100, 000
Units sold for Birr.43.75 each
Variable costs are Birr.18.75 per unit
Breakeven points occur when:
QBE = FC / (P – V)
QBE = Birr.100, 000 / (Birr.43.75 – Birr.18.75)
QBE = 4,000 Units
SBE = (QBE) (V) + FC
SBE = (4,000) (Birr.18.75) + Birr.100, 000
SBE = Birr.175, 000
Graphically,
Interpretation:At sales of 400 units, the firm’s EBIT should just equal to Birr 0. The firm will
have positive EBIT for sales greater than 400 units and negative EBIT, or a loss for sales less
than 400 units, along with the other values given constant.
Factors that determine BEP: A firm’s breakeven point is sensitive to a number of variables:
fixed operating cost (FC), the sale price per unit (P), and the variable operating cost per unit
(VC). Referring to Equation can readily see the effects of increases or decreases in these
variables. The sensitivity of the breakeven sales volume (Q) to an increase in each of these
variables is summarized in below Table 5.1. As might be expected, an increase in cost (FC or
VC) tends to increase the breakeven point, whereas an increase in the sale price per unit (P) will
decrease the breakeven point.
Sensitivity of Operating Breakeven Point to Increases in Key Breakeven Variables
Increase in variable Effect on breakeven point
Fixed operating cost (FC) Increase
Sale price per unit (P) Decrease
Variable operating cost per unit (VC) Increase
Note; Decreases in each of the variables shown would have the opposite effect from that
indicated on the breakeven point.
5.3. Method of financing
5.3.1. Debt financing

Akin to promissory notes, debtsare instruments for raising finance. Debenture holders are the
creditors of the company. The obligation of a company toward its debenture holders is similar to
that of a borrower who promises to pay interest and principal at specified times. Debentures
often provide more flexibility than term loans as they offer greater choice with respect to
maturity, interest rate, security, repayment, and special features.
Advantages of Debt Financing

 Tax deductibility of interest Disadvantages Debt Financing
 No dilution of control  Fixed interest and principal
 Lower issue costs repayment obligation
 Debt servicing burden is generally  Increased leverage raises the cost of
fixed in nominal terms equity
 Ideal maturity  Restrictive covenants
Use Equity capital as source of finance
when:
 The corporate tax rate applicable is high.

 Business risk exposure is low.
 Dilution of control is an issue.
 The assets of the investments are mostly tangible.
 The project has few growth options
5.3.2. Equity financing
Equity capital represents ownership capital as equity shareholders collectively own the
company. They enjoy the rewards and bear the risks of ownership
Use equity capital as the source of finance when;

 The corporate tax rate applicable is negligible.
 Business risk exposure is high.
 Dilution of control is not an important issue.
 The assets of the project are important issue.
 The assets of the project are mostly intangible.
 The project has many valuable growth options.
5.3.3. Lease financing

In leasing financing contract, the leasing company (lessor) provides the asset to the
business organization (lessee) and In turn the business commits to pay the lessor fixed
installments for a given period of time according to a pre-established timetable.
 There is also a provision for redemption when the contract expires.
 The asset assigned in leasing can be a plant or sometimes a very complex structure that is
assigned to the business on a turnkey basis after construction and initial testing. So the
lessee transfers the problems of organizing and monitoring the construction phase to the
leasing company. Use lease financing when: the above two alternatives are unnecessary.

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INFO LINK UNIVERSITY COLLEGE HAWSSA ACFN FM –I FOR 3r d year (R, W & E)

CHAPTER FIVE: FINANCING DECISION

Fig 5.1. The relationship between EBIT and business risk

Formula: The Operating Leverage can be calculated by the following formula:

Degree of Operating Leverage (DOL):

Interpretation:(1) Operating leverage may be favorable or unfavorable. In our given example

Degree of Financial Leverage (DFL):

EBIT 50,000 EBIT 100,000

(C) Composite Leverage / Combined Leverage

Composite Leverage (CL) = Operating Leverage X Financial Leverage

CL@6000 units = OL X FL = 3.0*1.25= 3.75 or contribution margin/EBT =150,000/40,000=3.75

Degree of Composite Leverage (DCL):

Higher the Composite Leverage = Higher the overall Risk

5.3. Overview of breakeven point

To find the sales break-even point:

5.3. Method of financing

5.3.1. Debt financing

Advantages of Debt Financing

 The corporate tax rate applicable is high.

5.3.2. Equity financing

Use equity capital as the source of finance when;

5.3.3. Lease financing

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