Capital and Leverage (2022-23) - Part-1

Subject-Financial Management-Sem-V Unit-4-Capital Structure ,Cost of Capital and Leverage
Unit -4
Capital Structure, Cost of Capital, Leverages
I) Capital Structure-Meaning, Factors to be considered while framing capital

structure, capital structure theories: Net income approach, net operating income
approach, Traditional theory,
Modigliani and Miller approach.
II) Cost of Capital -Cost of Capital: Meaning, Importance, Measurement of cost
of capital (i) specific cost: Cost of debt, Cost of equity shares, Cost of preference
shares; (ii) Overall cost:Weighted averages, cost of capital. (Practical Problems)
III) Leverages-Concept , Measurement of leverages -Operating ,Financial and
Combined leverage(Practical Problems)
I) Capital Structure
What is Capital Structure?
The term ‘structure’ means the arrangement of the various parts. So capital
structure means the arrangement of capital from different sources so that the long-
term funds needed for the business are raised.
Thus, capital structure refers to the proportions or combinations of equity share
capital, preference share capital, debentures, long-term loans, retained earnings and
other long-term sources of funds in the total amount of capital which a firm should
raise to run its business and used by a company to finance its overall operations
and growth.
RIT,Rajaramnagar Page 1
Debt comes in the form of bond issues or loans, while equity may come in the form
of common stock, preferred stock, or retained earnings. Short-term debt such as
working capital requirements is also considered to be part of the capital structure.
Definitions of capital structure -
“Capital structure refers to the mix of long-term sources of funds, such as,
debentures, long-term debts, preference share capital and equity share capital
including reserves and surplus.”
—I. M. Pandey.
“Capital structure of a company refers to the make-up of its capitalization and it

includes all long-term capital resources viz., loans, reserves, shares and bonds.”
—Gerstenberg.
“Capital structure is the combination of debt and equity securities that comprise a
firm’s financing of its assets.”
—John J. Hampton.
Importance of Capital Structure:

1. Increase in value of the firm:
A sound capital structure of a company helps to increase the market price of shares
and securities which, in turn, lead to increase in the value of the firm.
2. Utilisation of available funds:
A good capital structure enables a business enterprise to utilise the available funds
fully. A properly designed capital structure ensures the determination of the
financial requirements of the firm and raise the funds in such proportions from
various sources for their best possible utilisation. A sound capital structure protects
the business enterprise from over-capitalisation and under-capitalisation.
3. Maximisation of return:
A sound capital structure enables management to increase the profits of a company
in the form of higher return to the equity shareholders i.e., increase in earnings per
share. This can be done by the mechanism of trading on equity i.e., it refers to
increase in the proportion of debt capital in the capital structure which is the
cheapest source of capital. If the rate of return on capital employed (i.e.,
shareholders’ fund + long- term borrowings) exceeds the fixed rate of interest paid
to debt-holders, the company is said to be trading on equity.
4. Minimisation of cost of capital:
A sound capital structure of any business enterprise maximises shareholders’
wealth through minimisation of the overall cost of capital. This can also be done by
incorporating long-term debt capital in the capital structure as the cost of debt
capital is lower than the cost of equity or preference share capital since the interest
on debt is tax deductible.
5. Solvency or liquidity position:
A sound capital structure never allows a business enterprise to go for too much
raising of debt capital because, at the time of poor earning, the solvency is
disturbed for compulsory payment of interest to .the debt-supplier.
6. Flexibility:
A sound capital structure provides a room for expansion or reduction of debt
capital so that, according to changing conditions, adjustment of capital can be
made.
7. Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on business
to be diluted.
8. Minimisation of financial risk:
If debt component increases in the capital structure of a company, the financial risk
(i.e., payment of fixed interest charges and repayment of principal amount of debt
in time) will also increase. A sound capital structure protects a business enterprise
from such financial risk through a judicious mix of debt and equity in the capital
structure.
Factors Determining Capital Structure:
1. Risk of cash insolvency:
Risk of cash insolvency arises due to failure to pay fixed interest liabilities.
Generally, the higher proportion of debt in capital structure compels the company
to pay higher rate of interest on debt irrespective of the fact that the fund is
available or not. The non-payment of interest charges and principal amount in time
call for liquidation of the company.
The sudden withdrawal of debt funds from the company can cause cash
insolvency. This risk factor has an important bearing in determining the capital
structure of a company and it can be avoided if the project is financed by issues
equity share capital.
2. Risk in variation of earnings:
The higher the debt content in the capital structure of a company, the higher will be
the risk of variation in the expected earnings available to equity shareholders. If
return on investment on total capital employed (i.e., shareholders’ fund plus long-
term debt) exceeds the interest rate, the shareholders get a higher return.
On the other hand, if interest rate exceeds return on investment, the shareholders
may not get any return at all.
3. Cost of capital:
Cost of capital means cost of raising the capital from different sources of funds. It
is the price paid for using the capital. A business enterprise should generate enough
revenue to meet its cost of capital and finance its future growth. The finance
manager should consider the cost of each source of fund while designing the
capital structure of a company.
4. Control:
The consideration of retaining control of the business is an important factor in
capital structure decisions. If the existing equity shareholders do not like to dilute
the control, they may prefer debt capital to equity capital, as former has no voting
rights.
5. Trading on equity:
The use of fixed interest bearing securities along with owner’s equity as sources of
finance is known as trading on equity. It is an arrangement by which the company
aims at increasing the return on equity shares by the use of fixed interest bearing
securities (i.e., debenture, preference shares etc.).
If the existing capital structure of the company consists mainly of the equity
shares, the return on equity shares can be increased by using borrowed capital. This
is so because the interest paid on debentures is a deductible expenditure for income
tax assessment and the after-tax cost of debenture becomes very low.
Any excess earnings over cost of debt will be added up to the equity shareholders.
If the rate of return on total capital employed exceeds the rate of interest on debt
capital or rate of dividend on preference share capital, the company is said to be

trading on equity.
6. Government policies:
Capital structure is influenced by Government policies, rules and regulations of
SEBI and lending policies of financial institutions which change the financial
pattern of the company totally. Monetary and fiscal policies of the Government
will also affect the capital structure decisions.
7. Size of the company:
Availability of funds is greatly influenced by the size of company. A small
company finds it difficult to raise debt capital. The terms of debentures and long-
term loans are less favourable to such enterprises. Small companies have to depend
more on the equity shares and retained earnings.
On the other hand, large companies issue various types of securities despite the
fact that they pay less interest because investors consider large companies less
risky.
8. Needs of the investors:
While deciding capital structure the financial conditions and psychology of
different types of investors will have to be kept in mind. For example, a poor or
middle class investor may only be able to invest in equity or preference shares
which are usually of small denominations, only a financially sound investor can
afford to invest in debentures of higher denominations.
A cautious investor who wants his capital to grow will prefer equity shares.
9. Flexibility:
The capital structures of a company should be such that it can raise funds as and
when required. Flexibility provides room for expansion, both in terms of lower
impact on cost and with no significant rise in risk profile.
10. Period of finance:
The period for which finance is needed also influences the capital structure. When
funds are needed for long-term (say 10 years), it should be raised by issuing
debentures or preference shares. Funds should be raised by the issue of equity
shares when it is needed permanently.
11. Nature of business:
It has great influence in the capital structure of the business, companies having
stable and certain earnings prefer debentures or preference shares and companies
having no assured income depends on internal resources.
12. Legal requirements:
The finance manager should comply with the legal provisions while designing the
capital structure of a company.
13. Purpose of financing:
Capital structure of a company is also affected by the purpose of financing. If the
funds are required for manufacturing purposes, the company may procure it from
the issue of long- term sources. When the funds are required for non-
manufacturing purposes i.e., welfare facilities to workers, like school, hospital etc.
the company may procure it from internal sources.
14. Corporate taxation:
When corporate income is subject to taxes, debt financing is favourable. This is so
because the dividend payable on equity share capital and preference share capital
are not deductible for tax purposes, whereas interest paid on debt is deductible
from income and reduces a firm’s tax liabilities. The tax saving on interest charges
reduces the cost of debt funds.
Moreover, a company has to pay tax on the amount distributed as dividend to the
equity shareholders. Due to this, total earnings available for both debt holders and
stockholders is more when debt capital is used in capital structure. Therefore, if the
corporate tax rate is high enough, it is prudent to raise capital by issuing debentures
or taking long-term loans from financial institutions.
15. Cash inflows:
The selection of capital structure is also affected by the capacity of the business to
generate cash inflows. It analyses solvency position and the ability of the company
to meet its charges.
16. Provision for future:
The provision for future requirement of capital is also to be considered while
planning the capital structure of a company.
17. EBIT-EPS analysis:
If the level of EBIT is low from HPS point of view, equity is preferable to debt. If
the EBIT is high from EPS point of view, debt financing is preferable to equity. If
ROI is less than the interest on debt, debt financing decreases ROE. When the ROI
is more than the interest on debt, debt financing increases ROE.
CAPITAL STURCTURE THEORIES

1. Net Income Approach

2. Net Operating Income Approach
3. Traditional Approach
4. Modigliani and Miller Approach.
1. Net Income Approach:

This approach was suggested by Durand and he was in favor of financial leverage
decision. According to him, a change in financial leverage would lead to a change
in the cost of capital. In short, if the ratio of debt in the capital structure increases,
the weighted average cost of capital decreases and hence the value of the firm
increases.
So, according to this approach, a firm can minimise the weighted average cost of
capital and increase the value of the firm as well as market price of equity shares
by using debt financing to the maximum possible extent. The theory propounds
that a company can increase its value and decrease the overall cost of capital by
increasing the proportion of debt in its capital structure.
Assumptions:
(i) The cost of debt is less than the cost of equity.
(ii) There are no taxes.
(iii) The risk perception of investors is not changed by the use of debt.
The line of argument in favour of net income approach is that as the proportion of
debt financing in capital structure increase, the proportion of a less expensive
source of funds increases. This results in the decrease in overall (weighted average)
cost of capital leading to an increase in the value of the firm.
The reasons for assuming cost of debt to be less than the cost of equity are that
interest rates are usually lower than dividend rates due to element of risk and the
benefit of tax as the interest is a deductible expense.
On the other hand, if the proportion of debt financing in the capital structure is
reduced or say when the financial leverage is reduced, the weighted average cost of
capital of the firm will increase and the total value of the firm will decrease. The
Net Income (NI) Approach showing the effect of leverage on overall cost of capital
has been presented in the following figure.
The total market value of a firm on the basis of Net Income Approach can be
ascertained as below:
V= S + D
Where, V= Total market value of a firm
S = Market value of equity shares
= Earnings Available to Equity Shareholders (NI)/Equity Capitalisation Rate

D = Market value of debt,
and, Overall Cost of Capital or Weighted Average Cost of Capital can be
calculated as:
K0 = EBIT/v
Illustration 1:
X Ltd. is expecting an annual EBIT of Rs. 1 lakh. The company has Rs. 4 lakhs in
10% debentures. The cost of equity capital or capitalisation rate is 12.5%.
Calculate the total value of the firm according to the Net Income Approach:
Solution:
Illustration 2:
(a) A company expects a net income of Rs. 80,000. It has Rs. 2,00,000, 8%
Debentures. The equity capitalisation rate of the company is 10%. Calculate the
value of the firm and overall capitalisation rate according to the Net Income
Approach (ignoring income-tax).
(b) If the debenture debt is increased to Rs. 3,00,000, what shall be the value of the
firm and the overall capitalisation rate?
Solution:
Thus, it is evident that with the increase in debt financing the value of the firm has
increased and the overall cost of capital has decreased.
2. Net Operating Income Approach:

This theory as suggested by Durand is another extreme of the effect of leverage on
the value of the firm. It is diametrically opposite to the net income approach.
According to this approach, change in the capital structure of a company does not
affect the market value of the firm and the overall cost of capital remains constant
irrespective of the method of financing.
It implies that the overall cost of capital remains the same whether the debt-equity
mix is 50: 50 or 20:80 or 0:100. Thus, there is nothing as an optimal capital
structure and every capital structure is the optimum capital structure.
This theory presumes that:
(i) The market capitalises the value of the firm as a whole;
(ii) The business risk remains constant at every level of debt equity mix;
(iii) There are no corporate taxes.
The reasons propounded for such assumptions are that the increased use of debt
increases the financial risk of the equity shareholders and hence the cost of equity
increases. On the other hand, the cost of debt remains constant with the increasing
proportion of debt as the financial risk of the lenders is not affected.
Thus, the advantage of using the cheaper source of funds, i.e., debt is exactly offset
by the increased cost of equity.
According to the Net Operating Income (NOI) Approach, the financing mix is
irrelevant and it does not affect the value of the firm. The NOI approach showing
the effect of leverage on the overall cost of capital has been presented in the
following figure.
The value of a firm on the basis of Net Operating Income Approach can be
determined as below:
V = EBIT/K0
Where, V = Value of a firm
EBIT = Net operating income or Earnings before interest and tax
k0 = Overall cost of capital
The market value of equity, according to this approach is the residual value which
is determined by deducting the market value of debentures from the total market
value of the firm.
S=V–D
Where, S = Market value of equity shares
V = Total market value of a firm
D = Market value of debt
The cost of equity or equity capitalisation rate can be calculated as below:
= EBIT – I/V – D
Illustration 3:
(a) A company expects a net operating income of Rs. 1,00,000. It has Rs. 5,00,000,
6% Debentures. The overall capitalisation rate is 10%.Calculate the value of the
firm and the equity capitalisation rate (cost of equity) according to the Net
Operating Income Approach.
(b) If the debenture debt is increased to Rs. 7,50,000. what will be the effect on the
value of the firm and the equity capitalisation rate?
Solution:
Illustration 4:
H.B.P. Ltd. expects annual net operating income of Rs. 2,00,000. It has Rs.
5,00,000 outstaing debt, cost of debt is 10%. If the overall capitalisation rate is
12.5% what would be the total value of the firm and the equity capitalisation rate
according to the Net operating Income approach.
What will be the effect of the following on the total value of the firm and equity
capitalisation rate, if:
(i) The firm increases the amount of debt from Rs. 5,00,000 to Rs. 7,50,000 and
uses the proceeds of the debt to repurchase equity shares.
(ii) The firm redeems debt of Rs. 2,50,000 by issuing fresh equity shares of the
same amount.
Solution:
3. TRADITIONAL APPROACH:
The traditional approach, also known as Intermediate approach, is a compromise

between the two extremes of net income approach and net operating income
approach. According to this theory, the value of the firm can be increased initially
or the cost of capital can be decreased by using more debt as the debt is a cheaper
source of funds than equity.
Thus, optimum capital structure can be reached by a proper debt-equity mix.
Beyond a particular point, the cost of equity increases because increased debt
increases the financial risk of the equity shareholders. The advantage of cheaper
debt at this point of capital structure is offset by increased cost of equity. After this
there comes a stage, when the increased cost of equity cannot be offset by the
advantage of low-cost debt.
Thus, overall cost of capital, according to this theory, decreases up to a certain
point, remains more or less unchanged for moderate increase in debt thereafter; and
increases or rises beyond a certain point. Even the cost of debt may increase at this
stage due to increased financial risk.
The traditional view point on the relationship between the leverage, cost of capital
and the value of firm has been shown in the figures below:
The figures above show that there can be a range of optimal capital structure or a
particular level of optimal capital structure.
Illustration 5:
Compute the market value of the firm, value of shares and the average cost of
capital from the following information:
Assume that Rs. 4,00,000 debentures can be raised at 5% rate of interest whereas
Rs. 6,00,000 debentures can be raised at 6% rate of interest.
Solution:
Comments:
It is clear from the above that if debt of Rs. 4,00,000 is used the value of the firm
increases and the overall cost of capital decreases. But, if more debt is used to
finance in place of equity, i.e., Rs. 6,00,000 debentures, the value of the firm
decreases and the overall cost of capital increases.
Illustration 6:
A company’s current net operating income (EBIT) is Rs. 8,00,000. The company
has Rs. 20 lakhs of 10% debt outstanding. Its equity capitalisation rate is 15%. The
company is considering to increase its debt by raising additional Rs. 10 lakhs and
to utilise these funds to retire the amount of equity. However, due to increased
financial risk, the cost of entire debt is likely to increase to 12% and the cost of
equity it 18%.
You are required to compute the market value of the company using traditional
model and also make recommendations regarding the proposal:
Solution:
4.MODIGLIANI AND MILLER APPROACH:

It is a capital structure theory named after Franco Modigliani and Merton Miller.
MM theory proposed two propositions.
Proposition I: It says that the capital structure is irrelevant to the value of a firm.
The value of two identical firms would remain the same and value would not affect
by the choice of finance adopted to finance the assets. The value of a firm is
dependent on the expected future earnings. It is when there are no taxes.
Proposition II: It says that the financial leverage boosts the value of a firm and
reduces WACC. It is when tax information is available.
M&M hypothesis is identical with the Net Operating Income approach if taxes are
ignored. However, when corporate taxes are assumed to exist, their hypothesis is
similar to the Net Income Approach.
(a) In the absence of taxes. (Theory of Irrelevance):
The theory proves that the costs of capital is not affected by changes in the capital
structure or say that the debt-equity mix is irrelevant in the determination of the
total value of a firm. The reason argued is that though debt is cheaper to equity,
with increased use of debt as a source of finance, the cost of equity increases.
This increase in cost of equity offsets the advantage of the low cost of debt. Thus,
although the financial leverage affects the cost of equity, the overall cost of capital
remains constant. The theory emphasizes the fact that a firm’s operating income is
a determinant of its total value.
The theory further propounds that beyond a certain limit of debt, the cost of debt
increases (due to increased financial risk) but the cost of equity falls thereby again
balancing the two costs.
In the opinion of Modigliani& Miller, two identical firms in all respects except
their capital structure cannot have different market values or cost of capital
because of arbitrage process.
In case two identical firms except for their capital structure have different market
values or cost of capital, arbitrage will take place and the investors will engage in
‘personal leverage’ (i.e. they will buy equity of the other company in preference to
the company having lesser value) as against the ‘corporate leverage’; and this will
again render the two firms to have the same total value.
The M&M approach is based upon the following assumptions:
(i) There are no corporate taxes.
(ii) There is a prefect market.
(iii) Investors act rationally.
(iv) The expected earnings of all the firms have identical risk characteristics.
(v) The cut-off point of investment in a firm is capitalization rate.
(vi) Risk to investors depends upon the random fluctuations of expected earnings
and the possibility that the actual value of the variables may turn out to be different
from their best estimates.
(vii) All earnings are distributed to the shareholders.
MM approach in the absence of corporate taxes, i.e., the theory of irrelevance of
financing mix has been presented in the following figure:
Illustration 7:
The following information is available regarding Mid Air Enterprises:
(i) Mid Air currently has no debt, it is an all equity company;
(ii) Expected EBIT = Rs. 24 lakhs. EBIT is not expected to increase overnight, so
Mid Air is in no growth situation;
(iii) There are no taxes, so T = O per cent;
(iv) Mid Air pays out all its income as dividends;
(v) If mid Air begins to use debt, it can borrow at the rate k d = 8 per cent. This
borrowing rate is constant and it is independent of the amount of debt. Any money
raised by selling debt would be used to retire common stock, so Mid Air’s assets
would remain constant;
(vi) The risk of Mid Air’s assets, and thus its EBIT, is such that its shareholders
require a rate of return ke = 12 per cent, if no debt is used.
Using MM Model without corporate taxes and assuming a debt of Rs. 1 crore, you
are required to:
(a) Determine the firm’s total market value;
(b) Determine the firm’s value of equity;
(c) Determine the firm’s leverage cost of equity.
Solution:
(b) When the corporate taxes are assumed to exist. (Theory of Relevance):
Modigliani and Miller, in their article of 1963 have recognized that the value of the
firm will increase or the cost of capital will decrease with the use of debt on
account of deductibility of interest charges for tax purpose. Thus, the optimum
capital structure can be achieved by maximising the debt mix in the equity of a
firm.
According to the M & M approach, the value of a firm unlevered can be calculated
as.
where, Vu is value of unlevered firm

and, tD is the discounted present value of the tax savings resulting from the tax
deductibility of the interest charges, t is the rate of tax and D the quantum of debt
used in the mix.
Value of levered and unlevered firm under the MM model (assuming that
corporate taxes exist) has been shown in the following figure.
Illustration 8:
A company has earnings before interest and taxes of Rs. 1,00,000. It expects a
return on its investment at a rate of 12.5%. You are required to find out the total
value of the firm according to the Miller-Modigliani theory:
Solution:
Illustration 9:
There are two firms X and Y which are exactly identical except that X does not use
any debt in its financing, while Y has Rs. 1,00,000 5% Debentures in its financing.
Both the firms have earnings before interest and tax of Rs. 25,000 and the equity
capitalisation rate is 10%. Assuming the corporation tax of 50% calculate the value
of the firm using M & M approach:
Solution:
Illustration 10:
The following is the data regarding two companies ‘A’ and ‘B’ belonging to the
same equivalent risk class:
All profits after paying debenture interest are distributed as dividends.

You are required to explain how under Modigliani and Miller approach, an
investor holding 10% of shares in company ‘A’ will be better off in switching his
holding to company ‘B’
Solution:
As the net income of the investor in company ‘B’ is higher than the loss of income
from company ‘A ‘ due to switching the holdings, the investor will gain in
switching his holdings to company ‘B’.
Illustration 11:
Companies A and B belong to the same business-risk class. Average net operating
income before interest of each company is 7 100 lakhs. Other related information
is given below:
Rate of interest on debentures is 15% p.a. and the same is considered to be certain
by all the investors:
(a) In case the total market value of the two companies is not in equilibrium,
explain the process by which equilibrium is restored to according to Modigliani
and Miller theory.
(b) If the cost of equity is 27.78% for company A in equilibrium, what will it be for
company B?
Solution:
Illustration 12:
Compute the equilibrium values and capitalization rates of equity (Ke) of the
companies A and B on the basis of the following data. Assume that:
(i) There is no income tax, and
(ii) The equilibrium value of average cost of capital (P) is 8.5%.
Solution:
Part-2-Cost of Capital
Meaning-
Cost of capital refers to the discount rate that is used in determining the present value of
the estimated future cash proceeds of the business/new project and eventually deciding
whether the business/new project is worth undertaking or now. It is also the minimum
rate of return that a firm must earn on its investment which will maintain the market value
of share at its current level. It can also be stated as the opportunity cost of an investment,
i.e. the rate of return that a company would otherwise be able to earn at the same risk level
as the investment that has been selected.
Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders
and the debt- holders) to the business as a compensation for their contribution to the total
capital.
Components of Cost of Capital:
The cost of capital can be either explicit or implicit.
Explicit cost of any source of capital may be defined as the discount rate that equals that
present value of the cash inflows that are incremental to the taking of financing
opportunity with the present value of its incremental cash outflows.
Implicit cost is the rate of return associated with the best investment opportunity for the
firm and its shareholders that will be foregone if the project presently under consideration
by the firm was accepted.
Measurement of Cost of Capital has two parts:

Measurement of Cost of Capital has two parts:
I) Specific Cost of Capital
II) Weighted Cost of Capital
III)Marginal Cost of Capital
I) SPECIFIC COST OF CAPITAL

Specific Cost of Capital for each source of Capital: The first step in the measurement of the
cost of the capital of the firm is the calculation of the cost of individual sources of raising
funds. From the viewpoint of capital budgeting decisions, the long term sources of funds
are relevant as they constitute the major sources of financing the fixed assets. In calculating
the cost of capital, therefore the focus on long-term funds and which are:-
1. Debt (Debentures)
2. Preference Shares
3. Equity Capital
4. Retained Earnings
1. COST OF DEBT(DEBENTURES)
External borrowings or debt instruments do not confers ownership to the providers
of finance. The providers of the debt fund do not participate in the affairs of the
company but enjoys the charge on the profit before taxes. Long term debt includes
long term loans from the financial institutions, capital from issuing debentures or
bonds etc.
Features of Debentures Or Bonds:
(i) Face Value: Debentures or Bonds are denominated with some value; this
denominated value is called face value of the debenture. Interest is calculated
on the face value of the debentures. E.g. If a company issue 9% Non-
convertible debentures of ` 100 each, this means the face value is ` 100 and
the interest @ 9% will be calculated on this face value.
(ii) Interest (Coupon) Rate: Each debenture bears a fixed interest (coupon) rate
(except Zero coupon bond and Deep discount bond). Interest (coupon) rate is
applied to face value of debenture to calculate interest, which is payable to
the holders of debentures periodically.
(iii) Maturity period: Debentures or Bonds has a fixed maturity period for
redemption. However, in case of irredeemable debentures maturity period is
not defined and it is taken as infinite. Redemption Value: Redeemable
debentures or bonds are redeemed on its specified maturity date. Based on

the debt covenants the redemption value is determined.
(iv) Benefit of tax shield: The payment of interest to the debenture holders are
allowed as expenses for the purpose of corporate tax determination. Hence,
interest paid to the debenture holders save the tax liability of the company.
a) Cost of Irredeemable Debentures
b) Cost of Redeemable Debentures
2. COST OF PREFERENCE SHARES:
The preference share capital is paid dividend at a specified rate on face value of
preference shares. Payment of dividend to the preference shareholders are not
mandatory but are given priority over the equity shareholder. The payment of
dividend to the preference shareholders are not charged as expenses but treated as
appropriation of after tax profit. Hence, dividend paid to preference shareholders
does not reduce the tax liability to the company. Like the debentures, Preference
share capital can be categorized as redeemable and irredeemable.
Accordingly cost of capital for each type will be discussed here. a) Cost of
Irredeemable Preference Shares Preference shares issued by a company which are
redeemed on its maturity is called redeemable preference shares. Cost of
redeemable preference share is similar to the cost of redeemable debentures with
the exception that the dividends paid to the preference shareholders are not tax
deductible.
a) Cost of Irredeemable Debentures
b) Cost of Redeemable Debentures
3. COST OF EQUITY SHARE CAPITAL
Cost of Equity (ke) is the minimum rate of return which a company must earn to
convince investors to invest in the company's common stock at its current market
price. It is also called cost of common stock or required return on equity.
a) Dividend Price Approach
b) Earning Price Approach

c) Realized Yield Approach
4. COST OF RETAINED EARNINGS

Like another source of fund, retained earnings involve cost. It is the opportunity cost
of dividends foregone by shareholders. sometime cost of retained earnings remains
below the cost of equity due to saving in floatation cost and existence of personal tax.
In absence of any information on personal tax (tp): Cost of Retained Earnings (Kr) =
Cost of Equity Shares (Ke)
II) WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Weighted average cost of capital is the weighted average after tax costs of the
individual components of firm’s capital structure. That is, the after tax cost of each debt
and equity is calculated separately and added together to a single overall cost of
capital. The cost of weighted average method is preferred because the proportions of
various sources of funds in the capital structure are different. To be representative,
therefore, cost of capital should take into account the relative proportions of different
sources of finance. Weighted Cost of Capital is the average cost of all costs of various
sources of financing. Weighed Cost of Capital is also known as Composite Cost of
Capital, Overall Cost of Capital or Average cost of Capital.
Once, the specific cost of individual sources of finance is determined, we can compute
the weighted average cost of capital by putting weights to the specific costs of capital
in the proportion of the various sources of funds to the total.The weights (proportion)
may be given either by using Book value of the source or market Value of the source. If
there is a difference between market value and book vale weights, the weighted
average cost of capital would also differ. The market value of weighted average cost
would be overstated if market value of share is higher than the book value and vice-
versa. The market value weights are sometime preferred to the book value weights
because the market value represents the true value of the investors. However, the
market value weights suffer from the following limitations:
1. It is very difficult to determine the market values because of frequent fluctuations.
2 .With the use of market value weights, equity capital gets greater importance
Due to these limitations, it is better to use book value which is readily available.
There is a choice weight between the Book Value (BV) and Market Value (MV).
i) Book Value(BV) Weights
Book value weights are operationally easy and convenient. While using BV,
reserves such as share premium and retained profits are included in the BV of
equity, in addition to the nominal value of share capital.
Merits of Book Value Weights:
 Calculation of weights is simple
 Book Values provide a usable base, when firm is not listed or security
are not actively traded
 Book values are easily available from the published records of the firm
 Analysis of capital structure in terms of Debt-Equity ratio is base on
book-value
Demerits of Book value Weights:
 There is no relation between book valuses and present economic value
of various sources of capital
 Book value proportion is not consistent with the concept of cost of
capital because the latter is defined as the minimum rate of return to
maintain the market value of the firm.
Market Value(MV) Weights
Market value weight is more correct and represent a firm’s capital structure. It
is preferable to use MV weights for the equity. While using MV, reserves such as
share premium and retained profits are ignored as they are in effect
incorporated into the value of equity.
Merits of Market Value(MV) Weights
 Market values of securities are closely approximate the actual amount to

be received from their sale
 Costs of the specific socurses of fucnds that constitute the capital
structure of the firm are calculated using prevailaing and market prices
Demerits Market Value (MV)Weights
 Market Values may not be avialble when a firm is not listed or when the
securities of the firm are very thinly traded
 Market Value may be distortef when secutiews prices are influenced by
manipulation loading
 Equity Capital gets greater importance
 Most of the financial analysis prefer to use market value weights
because it is theoretically consistent and sound.
III) MARGINAL COST OF CAPITAL
Companies may raise additional funds for expansion. here, a financial manager
may be require to calculate the cost of additional funds to be raised.
The cost of additional funds is called as marginal cost of capital .
e.g. a firm at firm has Rs.1,00,00,000 capital with WACC of 12 % ,but it is
planned to raise Rs.5,00,000 for expansaion. such as additional funds, the cost
that is related to this Rs.5 lakhs is marginal cost of Capital.
Marginal Cost of Capital is the total combined cost of debt, equity, and
preference taking into account their respective weights in the total capital of
the company where such cost shall denote the cost of raising any additional
capital for the organization which aides in analyzing various alternatives of
financing as well as decision making.
Marginal Cost of Capital = Cost of Capital of Source of New Capital Raised
The weighted average cost of new or incremental capital is known as marginal
cost of Capital.So marginal cost of capital is the weigjhted avareg cost of new
capital using the marginal weights.
Marginal Weights represents proportion of various sources of funds to be

employed in rasing additional funds.
Marginal Cost of capital shall be equal to WACC,when a firm employs the
existing proportion of capital structure and some cost of component of Capital
structure.But in practice,WACC may not equal to marginal cost of capital due to
changes in proportion and cost of various socurse of funds used in rasing new
capital.
The marginal cost ignores the long term implications of the new financing
plans. Hence WACC should be preferred to maximize shareholders wealth in
the long term.
ORMULAE
Specific Cost of Capital
1. Cost of Debt(Debentures)
The cost of Debt is the rate of Interest payable on Debt.
Cost of Debt
Type -1 Irredeemable Debts
I
Kdb= ----- x 100
Before tax P
1
(At Par) Kdb=Cost of Debt before tax
I-Interest
P=Principal Amount or Proceed
I
Before tax at Kdb= ----- x 100
Premium NP
or Kdb=Cost of Debt before tax
2
I-Interest
Before tax at NP=Net Proceed
Discount NP( for premium)=Proceed + --% Premium
NP(for Discount)=Proceed - --% Discount
3 After tax I
Kda = ------ x (1-t) x 100
NP
where,
K da = After-tax cost of debt
t = Rate of tax, NP=Net Proceed
Type-2 Redeemable Debts
I +-----(RV + NP)
Kdb=-------------------------------- x 100
-------( RV + NP)
1 Before tax
2
where,
I = Annual Interest
n = Number of years in which debt is to be redeemed
RV = Redeemable value of debt
NP = Net proceeds of debentures
After tax
1
I(1-t) +-----(RV + NP)
Kdb= ------------------------------------ x 100
-------( RV + NP)
2 Where,
I = Annual interest
t = Tax rate
n = Number of years in which debt is to be redeemed
RV = Redeemable value of debt
NP = Net proceeds of debentures
2.Cost of Preference Shares
Type -1 Cost of Perpetual /Irredeemable Debts
At Par D
Kp=------- x 100
Kp=Cost of Preference Capital
D=Dividend
P=Proceed
Kp=------- x 100
At Premium NP
Kp=Cost of Preference Capital
Or D=Dividend
NP=Net Proceed
At Discount NP for Premium=Proceed +% of Premium
NP for Discount=Proceed -% Discount
Type-2 Cost of Redeemable Debts
(MV + NP)
D +-------------
Kpr=-------------------------------- x 100
-------( MV + NP)
where,
Kpr =Cost of Redeemable Preference Shares
d= Annual Dividend
n = Number of years in which Preference Shares t is to be

redeemed
MV = Maturity Value of Preference Shares
NP = Net proceeds of Preference Shares
3.Cost of Equity Capital

Method Formula
Dividend Yield Method D D
Or Ke=------ x 100 OR ---------- x 100
Dividend /Rice Ratio Method NP MP
Ke=Cost of Equity Capital
D=Expected Dividend per share
NP=Net Proceed per share
MP=Market Price per share
D1 D0(1 +g)
Ke=------ + G x 100 = ---------- + G x100
NP NP
OR
D1 D0(1 + g)
Ke=------ + G x 100 = ---------- + G x 100
MP MP
Dividend Yield plus(+) Growth in Dividend
Method
Ke=Cost of Equity Capital
D1=Expected Dividend per share= D0(1 +g)
NP=Net Proceed per share
G=Rate of growth in dividend
D0=Previous Year Dividend per share
MP= Market Price per share
Earning Yield Method Earnings Per share EPS
Ke=------------------------ x 100 i.e. -------------- x 100
Net Proceeds NP
OR
Earnings Per share EPS
Ke=------------------------------ x 100 i.e. -------------- x 100
Market Price per share MP
4.Cost of Retained Earning
Cost Of Retained Earnings D1 D1
Kr=----- + G x 100 OR Kr = ------- + G x 100
NP MP
Kr=Cost of retained Earning
D1=Expected Dividend at the end of the year
NP=Net proceeds of share issue
G=Rate of growth
MP=market price per share.
Cost Of Retained Kr=Ke (1-t) x(-b)

Earnings( for tax and cost of
purchasing new securities_
Kr=Cost of retained earnings
D=Expected dividend
G=Growth rate
t=tax rate
PART-3-Leverages
Introduction:
Leverage is common term in financial management which entails the ability to

amplify results at a comparatively low cost. In business, company's managers
make decisions about leverage that affect profitability.
According to James Horne, leverage is, "the employment of an asset or fund for
which the firm pays a fixed cost or fixed return".
When they evaluate whether they can increase production profitably, they
address operating leverage. If they are expecting taking on additional debt,
they have entered the field of financial leverage. Operating leverage and
financial leverage both heighten the changes that occur to earnings due to
fixed costs in a company's capital structures. Fundamentally, leverage refers
to debt or to the borrowing of funds to finance the purchase of a company's
assets.
Business proprietors can use either debt or equity to finance or buy the
company's assets. Use of debt, or leverage, increases the company's risk of
bankruptcy. It also upsurges the company's returns, specifically its return on
equity. It is a fact because, if debt financing is used rather than equity
financing, then the owner's equity is not diluted by issuing more shares of
stock.
Investors in a business like for the business to use debt financing but only
up to a point. Investors get nervous about too much debt financing as it drives
up the company's default risk.
Types of Leverages –
Leverage is of three types:
1. Operating Leverage,
2. Financial Leverage, and
3. Combined Leverage.
Type 1. Financial Leverage:
Financial Leverage is a tool with which a financial manager can maximise the
returns to the equity shareholders. The capital of a company consists of
equity, preference, debentures, public deposits and other long-term source of
funds. He has to carefully select the securities to mobilise the funds. The
proper blend of debt to equity should be maintained.
The ratio through which he balances the mix of debt applied on the capital mix
offers benefits to the equity shareholders is known as Trading on Equity. As
the debt is associated with the cost of interest that can be directly charged to
profit and loss account or charged against the profit can reduce the burden of
income tax. The benefit so gained will be passed on to the equity shareholders.
In such circumstances the EPS will be more.
If the company prefers to raise the amount of debt instead of equity, it will
lose the opportunity of charging the interest directly against the profit, as a
result of this, it had to pay more tax to the government and in turn earnings
available to equity shareholders would reduce. Hence, in other words,
financial leverage refers to the use of fixed charge securities in the
capitalisation of company to produce more gains for the equity shareholders.
Computation of Financial Leverage:
Degree of Financial Leverage (DFL) measures the percentage change in EPS
for a given percentage change in operating income or earnings before interest
and taxes (EBIT).
When there is No Preference Dividend then the following formula can

also be used for the calculation of DFL:
Thus, the financial leverage signifies the relationship between the earning
power on equity capital and rate interest on borrowed capital. If the earnings
of the company has more amount of fixed cost of interest (which would arise
due to more debt capital), the overall returns of a company get reduced and
financial risk increases. This may be an unfavourable situation for business
concern and practically not advocated. The more accepted ratio between debt
to equity is 2:1. This ratio favours leverage effect on equity shares and would
get higher percentage of earnings.
Financial leverage arises due to the presence of fixed Financial Costs (such as
interest) in the cost structure of a company. Financial leverage is the use of
fixed Financial Costs to magnify the effect of change in operating profit (EBIT)
on Earnings per share (EPS). Thus, Financial leverage implies that a given %
change in EBIT results into a more than proportionate change in EPS
(Earnings per share) of the company in the same direction.
Financial Leverage measures the sensitivity of a company’s EPS to a given
change in its operating profit (EBIT). A company will not have Financial
Leverage if it does not have any fixed Financial Costs. At the same time the
higher the fixed Financial costs, the higher will be Financial Leverage. Fixed
financial costs result from the use of debt capital in the capital structure of a
company.
Therefore Financial Leverage is concerned with the capital structure decision

of a company. This is because debt capital gives rise to fixed Financial Costs
which in turn results into Financial Leverage.
Financial Leverage gives rise to ‘Financial Risk’. Financial Risk is the risk of
not being able to meet fixed Financial Costs such as interest and hence it may
force a company into bankruptcy. The higher the fixed Financial Costs, the
higher will be Financial Leverage and the higher will be Financial Risk of the
business.
Features of Financial Leverage:
Following are the features of Financial Leverage:
i. It is concerned with fixed Financial Costs or debt capital of a company.
ii. It measures the relationship between operating profit (EBIT) and earnings
per share (EPS).
iii. It gives rise to Financial Risk in a business.
iv. It is higher in a company using high amount of debt.
Important Note:
However when there is preference dividend as well, then it is better to use the
first formula. This is because while interest expenses are tax deductible,
preference dividend is not tax deductible in nature. Hence earnings available
to equity shareholders get reduced further by the amount of preference
dividend which is fixed.
i. Fixed Financial costs are those Financial Costs which are to be paid
irrespective of the amount of profit or loss. These costs remain constant
irrespective of the amount of operating profits. The examples are interest on
bonds and debentures, interest on bank loans etc.
ii. EBIT = Sales Revenue – Variable Costs – Fixed operating costs.

iii. Earnings Before Taxes (EBT) = EBIT – Interest. EBT is also known as Profit
before Tax (PBT).
Interpretation of Financial Leverage:
1. If DFL = 1 then a given % change in EBIT will result in the same % change in
EPS in the same direction i.e. 1 % increase in EBIT will result in 1% increase in
EPS. Similarly 1% decrease is EBIT will result in 1% decrease in EPS. In such a
case there is effectively no financial leverage.
2. A company should have Financial Leverage only if its operating profit is
higher than its interest costs. Otherwise it will result into more harm to the
EPS of the company.
3. If DFL > 1, for example if DFL = 1.5 then 1% increase in EBIT will result in
1.5% increase in EPS. Similarly 1% decrease is EBIT will result in 1.5%
decrease in EPS. In such a case there is FINANCIAL LEVERAGE.
4. The higher the value of DFL, the higher will be financial leverage.
5. Financial Leverage is favourable when operating profits are increasing
because then the EPS will increase by a higher proportion. Financial leverage
is unfavourable when operating profits are decreasing because then the EPS
will decrease by a higher proportion.
6. When comparing two or more companies, the company with the highest
DFL is the company the EPS of which is most “sensitive” to changes in
operating profits.
7. A company should use high financial leverage if its ROI is higher than the
cost of debt. In that case the effect on EPS will be magnified.
Financial Risk:
Financial risk is the risk of not being able to meet fixed financial obligations
like payment of interest on debt. This risk is a function of the relative amount
of long term debt that a company uses to finance its assets.
The higher the proportion of debt capital in the total capitalization of a
company, the higher will be degree of financial leverage and the higher will be
the probability of the company of not being able to service the debt capital,
which in turn means higher financial risk.
Hence there is a positive relationship between financial leverage and financial
risk.
Application of Financial Leverage:
Financial leverage emerges out of the capital structure decision of a company.
A finance manager can decide whether the company should use more financial
leverage or not. For deciding on whether to further use debt in the capital
structure or not the finance manager should compare the cost of debt
financing with the company’s average Return on Investment (ROI).
i. If ROI > Cost of Debt:
This implies that the company will earn a return on its invested debt capital
which is more than the cost of those debt funds. Hence, use of debt will result
in positive net benefits to shareholders and therefore more debt should be
employed. This situation is also known as Favourable Financial Leverage or
Trading on Equity.
ii. If ROI = Cost of Debt:
This implies that the company will earn a return on debt which equals the cost
of those debt funds. Hence, use of debt will not provide any additional net
benefit to shareholders. Instead use of more debt will only increase financial
risk. Hence, more leverage should not be used.
iii. If ROI < Cost of Debt:
This implies that the company will earn a return on invested debt capital
which is less than the cost of those debt funds. Hence, use of debt will result
into net loss to the company and earnings to equity shareholders will decline.
So in this case, company should not use any more debt.
Significance of Financial Leverage:
i. Financial leverage leads to more than proportionate increase in EPS if
operating profits of the company are increasing. This provides additional
benefits to equity shareholders. However, it can also cause a manifold decline
in EPS when EBIT declines. So, it is important to use financial leverage
judiciously.
ii. Debt is a cheaper source of funds than equity and preference capital. Hence,
use of more debt reduces the overall or weighted average cost of capital
(WACC) of the company. This contributes to the objective of shareholders’
wealth maximization.
iii. Most companies use WACC as discount rate in capital budgeting decisions.
A reduction in WACC due to the use of financial leverage means that more
projects will be profitable and can be selected.
The two quantifiable tools, viz., operating and financial leverage are adopted
to know the earnings per share and also which shows the market value of the
share. (Price earning ratio by EBIT) Thus, financial leverage is a better tool
compared to operating leverage. Change in EPS due to changes in EBIT results

in variation in market price.
Therefore, financial and operating leverages act as a handy tool to the analyst
or to the financial manager to take the decision with regard to capitalisation.
He can identify the exact relationship between the EPS and EBIT and plan
accordingly. High leverage indicates high financial risks which would signal
the finance manager to select the securities carefully.
Type : 2. Operating Leverage:

There are two major classifications of costs in the organisation. They are- (a)
Fixed cost, (b) Variable cost.
The operating leverage has a bearing on fixed costs. There is a tendency of the
profits to change, if the firm employs more of fixed costs in its production
process, greater will be the operating cost irrespective of the size of the
production. The operating leverage will be at a low degree when fixed costs
are less in the production process.
Features of operating leverage:
i. It is concerned with fixed operating costs or fixed assets of a company.
ii. It measures the relationship between sales revenue and operating profit.
iii. It gives rise to operating risk or business risk in a business.
iv. It is higher in a manufacturing company having huge amount of fixed
operating costs than a trading company which has less amount of fixed assets.
Operating leverage shows the ability of a firm to use fixed operating cost to
increase the effect of change in sales on its operating profits. It shows the
relationship between the changes in sales and the charges in fixed operating
income. Thus, the operating leverage has impact mainly on fixed cost, variable
cost and contribution.
It indicates the effect of a change in sales revenue on the operating profit
(EBIT). Higher the operating leverage indicates higher the amount of fixed
cost and reduces the operating profit and increases the business risks.
Computation of Operating Leverage:
Degree of Operating Leverage (DOL) is the percentage change in a company’s
operating profit (EBIT) resulting from a percentage change in sales.
Therefore, Degree of Operating Leverage (DOL) can be calculated as
below:
i. Fixed operating costs are those operating costs which are independent of
output. These costs remain constant irrespective of the production and sales
data. The examples are—building rent, depreciation etc. Variable costs are
costs which vary proportionately with output. Example – wages, utilities,
materials etc.
ii. Contribution = Sales Revenue – Variable Costs.
iii. Earnings Before Interest and Taxes (EBIT) = Contribution – Fixed
operating Costs.
Interpretation of Operating Leverage:
1. If DOL = 1 then a given % change in sales will result in the same % change in
operating profit in the same direction i.e. 1% increase in sales will result in
1% increase in operating profit. Similarly 196 decrease is sales will result in
1% decrease in operating profit. In such a case there in effectively NO
OPERATING LEVERAGE.
2. A company should have operating leverage only if its contribution margin is
higher than its fixed operating costs. Otherwise it will result into more harm
to the company.
3. If DOL > 1 for example if DOL =1.5 then 1% increase in sales will result in
1.5% increase in operating profit. Similarly 1% decrease is sales will result in
1.5% decrease in operating profit. In this case there is OPERATING
LEVERAGE. The higher the value of DOL, the higher will be operating leverage.
4. Operating leverage is favourable when sales are increasing because then the
operating profits will increase by a higher proportion. Operating leverage is
unfavourable when sales are decreasing because then the operating profits
will decrease by a higher proportion.
5. When comparing two or more companies, the company with the highest
DOL is the company the profits of which are most “sensitive” to changes in
sales.
Operating Risk (or Business Risk):
Operating risk is the risk of not being able to meet fixed operating costs like
depreciation, rent etc. This risk is a function of the amount of fixed assets
which involve fixed operating costs. The higher the proportion of fixed
operating costs in the cost structure of a company, the higher will be
operating risk.
Operating risk is also defined as variability in operating profits (EBIT) due to
changes in sales. Hence there is a positive relationship between operating
leverage and operating risk. The higher the operating leverage the higher is
the operating risk of a company.
Significance of Operating Leverage:
If a company has higher degree of operating leverage, then even a small
change in sales levels will have a significantly higher effect on EBIT in the
same direction. A small increase in sales will significantly increase the op-
erating profit (EBIT). At the same time, a small decrease in sales will also
significantly decrease the operating profits (EBIT).
Therefore, a company should always try to avoid having higher operating
leverage if it is not sure about the stability of its sales. If the sales are
fluctuating and highly vulnerable then a high DOL condition is a highly risky
proposition.
Applications of Operating Leverage:
Operating leverage is used for the following purposes:
i. For selection of Investment projects – A company should be careful while
selecting investment projects. A company should select a project with lower
operating leverage if all other things remain same.
ii. Operating leverage is important for long term profit planning and budgeting
as one can easily compute the effect of a change in sales revenue on operating
profit.
iii. DOL indicates operating or Business Risk of a company – Business Risk is
the risk of not being able to meet fixed operating cost obligations. It can be
measured as the variability of a company’s operating profit (EBIT). One of the
main sources of variability in operating profits is change in sales which is very
well captured by the degree of operating leverage. Hence degree of operating
leverage in a way indicates the operating risk or business risk level of a
company. The higher the DOL the higher will be business risk.
iv. Capital structure decision i.e. the mix of debt and equity capital, is also
effected by the company’s operating leverage. Generally when operating
leverage is high, companies should avoid excessive use of debt.
In the previous illustration, we have learnt that 25,000 units of production

will not yield any operating profit or the company has reached the break-even.
Any units which are produced beyond 25,000 units yields operating profits.
Therefore, any increases in sales, fixed costs remaining same, increases

operating profit. The increase in percentage operating income due to
percentage, of increase in sales is called as “Degree of operating leverage”.
This is calculated as follows:
Type : 3. Combined Leverage:

This leverage shows the relationship between a change in sales and the
corresponding variation in taxable income. If the management feels that a
certain percentage change in sales would result in percentage change to
taxable income they would like to know the level or degree of change and
hence they adopt this leverage. Thus, degree of leverage is adopted to forecast
the future study of sales levels and resultant increase/decrease in taxable
income. This degree establishes the relationship between contribution and
taxable income.
Operating leverage explains the business risk complexion of the company

whereas financial leverage deals with the financial risk of the company. But
what matters for a company is its ‘Total Risk’. Total risk of a company is
captured by the ‘Combined leverage’ of the company. Hence, Combined
Leverage is a measure of total risk of a company. Operating leverage shows
the effect of change in sales revenue on EBIT and financial leverage shows the
effect of change in EBIT on EPS.
So, a company having both operating leverage and financial leverage will have
to see the effect of change in sales revenue on its EPS. Combined leverage
shows the effect of change in sales revenue on EPS of a company. Combined
leverage is calculated as the multiplication of Operating leverage and Financial
Leverage.
Interpretation of Combined Leverage:

i. If DCL = 1 then there is no combined risk of the company.
ii. If DCL > 1 then there is combined risk. Let us assume that DCL = 2.25 then it
means that 1% increase or decrease in sales revenue will result into 2.25%
increase or decrease in company’s EPS. In a generalised way we can say that if

DCL = K then an X% increase or decrease in Sales will produce a K*X%
increase or decrease respectively in EPS. For Example – If DCL = 4, then a 1%
increase in sales will result in a 4% increase in EPS.
iii. DCL measures the total or combined risk of a company. Total or combined
company risk is the variability in EPS. Total company risk = business risk X
financial risk. Thus risk in a company is multiplicative in nature and not
additive.
iv. Combined leverage or combined risk can be managed by managing
operating leverage and financial leverage. If a company has higher operating
leverage then it should use low financial leverage so that combined leverage
does not increase manifold. If a company has lower operating leverage then it
may afford to have higher financial leverage.
v. A company with relatively high level of DCL is seen as riskier than a
company with less combined leverage, as high DCL means more fixed costs to
the company.
The impact of different combinations of operating and financial leverage
on combined leverage is shown in the Table:
Example:
A company, has a sales of Rs.2 lakh. The variable costs are 40 per cent of the
sales and fixed expenses are Rs.60,000. The interest on borrowed capital is
assumed to be Rs.20, 000. Compute the combined leverage and show the
impact on taxable income when sales increases by 10 per cent.
Solution:
It should be observed that the leverage is ascertained from a particular sales

point. When different levels of sales are adopted, different degrees of
composite leverages are obtained. When the volume of sales increases, fixed
expenses remains same, the degree of leverage falls. This happens because of
existence of fixed charges in the cost structure.
Significance of Operating and Financial Leverage:
These two leverages are used to know the impact on earnings per share and
the price-earning ratio. As the financial leverage is more effective on EPS, it is
popularly used than operating leverage. The different combination of debt to
equity helps the management to maximise the earnings to the equity
shareholders. This helps the management to achieve wealth maximisation in
the long run.
Continuous increase in the size of the debt increases the financial risks. The
majority of earnings will directly goes to meet the interest cost on borrowings.
It adversely affects the overall performance of the organisation. Hence, he
should evaluate the different mix of capital involving financial risk to the firm.
Operating leverage is based on the principle of marginal costing, where BEP
can be calculated at different level of sales. Any increase of sales beyond BEP
sales will yield higher operating profit, (fixed cost remain constant). Any
change in sales due to the change in operating cost results in higher operating
profits. Therefore, operating leverage is said to be “First phase Leverage”
which magnifies the profit due to change in sales volume.
The financial leverage is said to be a “Second phase Leverage” as it starts off at
the point where the operating leverage stops. These two leverages are
properly blended to have profit maximisation and wealth maximisation which

are the two objectives of financial management.
Financial Risk:
Financial leverage not only maximises the returns to shareholders but also
exposes a firm to high financial risk, (if it is unplanned). The theory says
‘leverage effect can be enjoyed only up to a particular point of time or stage’,
(if all other things are favourable). If it crosses the expected line (more debt
and less equity), increases the financial risk (interest burden) and ultimately it
leads to insolvency. Capital structure only through equity is also not
favourable to the company, as it reduces EPS. (Because of nonexistence debt
capital). The entire earnings of the company will become taxable, as a result of
this, it has to declare lower percentage of dividend, in the long run, and it
would directly affect the market value of shares.
Business Risk:
Business risk is related to the investment decisions or assets mix of the firm.
Business risk may be defined as the variability in return on assets. Such a
variability is the result of internal and external environment, in which the firm
has to operate. Given the environment in which firm has to operate, business
risk is an unavoidable risk. Therefore, it is the basic duty of the financial
executives to take both the risks in taking financial as well as investment
decisions.
The first aspect of financial risk, viz., the relatively higher variability in the
shareholders’ earnings can be measured by calculating coefficient of variation
of the shareholders’ expected earnings. The coefficient of variation of the
expected earnings from total assets, defined business risk.
Where (σ = standard deviation about the probability distribution of expecting

earnings and X̅ = average expected earnings). If the expected earnings of the
firm and the expected earnings of the shareholders would be equal in the case
of debt free firm. But the financial risk derived for a levered firm as the
coefficient of variation of its shareholder’s earnings would be greater than
that of an identical debt free firm.
Example:
The expected future average annual net operating incomes of firms A and B
are Rs.40, 000 with the standard deviation of Rs.10, 000. First A is debt free
while Firm A is debt free while firm B has 10 debentures of Rs.60, 000
ignoring taxation, ascertain which firm is risky from the shareholder’s point of
view?
Solution:
Since coefficient of variation of Firm B is greater than that of A, Firm B is more

risky from the shareholder’s point of view.
Difference between Operating and Financial Leverage
Operating Average Financial Average
1. Operating leverage is related to the 1. Financial leverage is more

investment activities (capital concerned with financial matters
expenditure decision). (Mixing of debt Equity in. Capital
structure).
2. The fluctuation in the EBIT can be 2. The changes of EPS due to D:E Mix
predicated with the help of operating is predicted by financial leverage.
leverage.
3. Financial manager uses the 3. The uses financial leverage to make
operating leverage to identify the decisions in the liability side of the
items of assets side of the Balance. Balance Sheet.
4. Operating leverage is used to 4. Financial leverage is used to
predict Business risk. analyse the financial risk.

Capital and Leverage (2022-23) - Part-1

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Subject-Financial Management-Sem-V Unit-4-Capital Structure ,Cost of Capital and Leverage

I) Capital Structure-Meaning, Factors to be considered while framing capital

“Capital structure of a company refers to the make-up of its capitalization and it

Importance of Capital Structure:

capital or rate of dividend on preference share capital, the company is said to be

CAPITAL STURCTURE THEORIES

1. Net Income Approach

1. Net Income Approach:

= Earnings Available to Equity Shareholders (NI)/Equity Capitalisation Rate

2. Net Operating Income Approach:

The traditional approach, also known as Intermediate approach, is a compromise

4.MODIGLIANI AND MILLER APPROACH:

where, Vu is value of unlevered firm

All profits after paying debenture interest are distributed as dividends.

Components of Cost of Capital:

The cost of capital can be either explicit or implicit.

Measurement of Cost of Capital has two parts:

I) SPECIFIC COST OF CAPITAL

debentures or bonds are redeemed on its specified maturity date. Based on

a) Dividend Price Approach

b) Earning Price Approach

4. COST OF RETAINED EARNINGS

 Market values of securities are closely approximate the actual amount to

Marginal Weights represents proportion of various sources of funds to be

Type -1 Irredeemable Debts

Kda = ------ x (1-t) x 100

K da = After-tax cost of debt

t = Rate of tax, NP=Net Proceed

Type-2 Redeemable Debts

n = Number of years in which debt is to be redeemed

RV = Redeemable value of debt

NP = Net proceeds of debentures

I(1-t) +-----(RV + NP)

Kdb= ------------------------------------ x 100

n = Number of years in which debt is to be redeemed

RV = Redeemable value of debt

NP = Net proceeds of debentures

2.Cost of Preference Shares

Type -1 Cost of Perpetual /Irredeemable Debts

Kp=Cost of Preference Capital

Kp=Cost of Preference Capital

At Discount NP for Premium=Proceed +% of Premium

NP for Discount=Proceed -% Discount

Type-2 Cost of Redeemable Debts

Kpr =Cost of Redeemable Preference Shares

n = Number of years in which Preference Shares t is to be

MV = Maturity Value of Preference Shares

NP = Net proceeds of Preference Shares

3.Cost of Equity Capital

Dividend Yield Method D D

Or Ke=------ x 100 OR ---------- x 100

Dividend /Rice Ratio Method NP MP

Ke=Cost of Equity Capital

D=Expected Dividend per share

NP=Net Proceed per share

MP=Market Price per share

Ke=------ + G x 100 = ---------- + G x100

Ke=------ + G x 100 = ---------- + G x 100