CAPITAL STRUCTURE

Degree of Financial Leverage, DFL

Definition
The degree of financial leverage (DFL) is a ratio used in corporate finance to measure the
sensitivity of earnings per share (EPS) to the fluctuation in the operating income (also called
earnings before interest and taxes or EBIT). The effect of financial leverage emerges if a
company uses debt financing. Interest payments on fixed-income securities are fixed and affect
the EPS (the higher they are, the lower the EPS). Thus, the fluctuation of EPS varies to a greater
extent than fluctuation of EBIT.
The DFL ratio shows the percentage change in EPS in response to a 1% change in EBIT!
Low vs. High Financial Leverage
Low financial leverage indicates a low proportion of debt in a company’s capital structure, which
means both lower financial risk and lower sensitivity of EPS to fluctuation in EBIT. Other things
being equal, such companies are more stable and less sensitive to changes in operating income.
High financial leverage means a high proportion of debt in a company’s capital structure. Such
companies are exposed to greater financial risk, and stockholders’ return is highly volatile. So,
such companies are more responsive to changes in operating income.

Formula
The degree of financial leverage ratio is the percentage change in earnings per share (EPS) over
the percentage change in earnings before interest and taxes (EBIT).
DFL % Change in EPS
=  % Change in EBIT
The percentage change in EPS is the change in EPS (∆EPS) over EPS.
∆EP
% Change in EPS
S
= 
EPS
In turn, the change in EPS can be calculated as follows:
(∆EBIT - ∆I) × (1 - ∆EBIT × (1 -
∆EPS
T)  = T)
= 
N N
Here ∆EBIT is a change in EBIT, ∆I is a change in the interest payment, and T is a tax rate.
Because the interest payment is fixed, change in the interest payment is equal to zero (∆I=0).
The EPS is calculated as follows:
(EBIT - I) × (1 -
EPS
T)
= 
N
Here I represents the interest payment, and N is a number of preferred stocks outstanding.
Thus, the percentage change in EPS can be defined as follows:
∆EBIT × (1 - T) ∆EBIT × (1 -
N T) N ∆EBIT
% Change in EPS
(EBIT - I) × (1 -  = N  × (EBIT - I) × (1 -  = EBIT -
= 
T) T) I
N
The percentage change in EBIT is the change in EBIT over the EBIT.
∆EBI
% Change in EBIT
T
= 
EBIT
So, the degree of financial leverage can be calculated using the following formula.
∆EBIT
EBIT -
DFL
I  = ∆EBIT  × EBIT  = EBIT
= 
∆EBIT EBIT - ∆EBI EBIT -
EBIT I T I
Degree of financial leverage and preferred stock
If a company has preferred stocks outstanding, the formula above must be modified, taking into
account preferred dividends. In this case, earnings per share are found as follows:
(EBIT - I) × (1 - T) -
EPS
D
= 
N
Here D is preferred dividends, and N is a number of preferred stocks outstanding. So the change
in earnings per share is
(∆EBIT - ∆I) × (1 - T) - ∆EBIT × (1 -
∆EPS
∆D  = T)
= 
N N
where ∆D is the change in preferred dividends. As interest (I) and preferred dividends (D) are
constant, hence ∆I=0 and ∆D=0.
The percentage change in EPS can be determined as follows:
∆EBIT × (1 - T) ∆EBIT × (1 -
N T) N ∆EBIT × (1 - T)
% Change in
(EBIT - I) × (1 -  = N  × (EBIT - I) × (1 -  = (EBIT - I) × (1 -
EPS = 
T) - D T) - D T) - D
N
Thus, the degree of financial leverage ratio adjusted to preferred dividends is
∆EBIT × (1 - T)
(EBIT - I) × (1 - T) -
DFL
D  = ∆EBIT × (1 - T)  × EBIT  = EBIT × (1 - T)
= 
∆EBIT (EBIT - I) × (1 - T) - ∆EBI (EBIT - I) × (1 - T) -
EBIT D T D
or
DFL EBIT
=  EBIT - I D
 1-
- 
  T
Example
Two companies have the same EBIT of $3,000,000 but different capital structure. Company Y is
mostly focused on equity financing using both common and preferred equity. Its preferred
dividend payment is $150,000, and the interest payment is $250,000. By contrast, Company Z
tends to use debt financing and has only common equity. Its interest payment is $1,250,000. The
tax rate for both companies is 30%.
The degree of financial leverage of Company Y is 1.18 and 1.71 for Company Z.
EBIT $3,000,000
DFL of Company Y
 =  $150,00  = 1.18
=  $3,000,000 - $250,000
EBIT - I -  D 0
- 
  1-T   1 - 0.30  

EBIT $3,000,000
DFL of Company Z
 =  $3,000,000 -  = 1.71
= 
EBIT - I $1,250,000
Thus, Company Z is more sensitive to fluctuations in EBIT than Company Y. For example, if
EBIT of both companies rises by 5%, the EPS of Company Y will increase by 5.9% (5 × 1.18),
and the EPS of Company Z will increase by 8.55% (5 × 1.71). In contrast, the drop in EBIT by
10% will lead to a decrease in the EPS of Company Y by 11.8% and by 17.1% for Company Z.

Degree of Combined Leverage, DCL

Introduction
The degree of combined leverage (DCL) is a ratio that summarizes the effect of both operating
and financial leverage. This ratio shows the percentage change in earnings per share (EPS)
caused by a 1% change in sales. The higher its value, the more vulnerable a company is for a
decrease in sales.
Low vs. high combined leverage
The combined leverage summarizes the effect of fixed operating costs and fixed financial costs
on a company’s earnings per share (EPS). That ratio is a measure of the total risk of a business
because it includes both operating risk and financial risk.
A high value DCL ratio means that a large proportion of a company’s total costs are fixed, and
incremental sales will result in a higher incremental EPS. Other things being equal such
companies have to generate more sales to cover their total fixed costs.
A smaller proportion of fixed operating and financial costs will result in a lower value DCL ratio,
which means lower incremental EPS on incremental sales and lower sensitivity to the slippage in
sales.
Formulas and Calculation
In general terms, the degree of combined leverage can be calculated as the percentage change
in sales over the percentage change in EPS.
DCL % Change in EPS
=  % Change in Sales
It can be alternatively defined as the combined effect of degree of operating leverage (DOL)
and degree of financial leverage (DFL).
DCL = DOL × DFL
In terms of DOL and DFL formulas, the formula above can be modified in the following way:
DCL Contribution Margin  × EBIT  = Contribution Margin  = S - TVC
= 
EBIT EBIT - EBIT - I S - TVC - FC
 I -I
Here EBIT represents earnings before interest and taxes, S is sales, TVC is total variable costs,
FC is fixed cost, and I represents the interest payment.
The formula above must be modified if there are preferred stocks outstanding.
DCL S - TVC Contribution Margin
 = 
=  D D
S - TVC - FC - I
1- EBIT - I - 
- 
  T   1-T
Here D is preferred dividends, and T is the tax rate.
Example
Let’s assume that two companies have the following financial results:
Company Y:
 Sales: $1,000,000
 Total variable operating costs: $400,000
 Fixed operating costs: $200,000
 Interest: $50,000
Company Z:
 Contribution margin: $400,000
 Earnings before interest and taxes: $300,000
 Interest: $75,000
 Preferred dividends: $35,000
 Tax rate is 30%.
The degree of combined leverage of Company Y is 1.71 and 2.29 for Company Z.
S - TVC $1,000,000 - $400,000
DFL of Company Y =   =  $1,000,000 - $400,000 - $200,000 -  = 1.71
S - TVC - FC - I $50,000

Contribution
Margin $400,000
DFL of Company Z =   =   = 2.29
$35,00
D $300,000 - $75,000 0
EBIT - I - 
- 
  1-T   1 - 0.30  

If both companies face a 5% decrease in sales, Company Y loses 8.55% (5 × 1.71) of EPS and
Company Z loses 11.45% (5 × 2.29).

EBIT-EPS Analysis
The EBIT-EPS analysis gives the best ratio of debt to equity which the businesses
can use to find an optimum balance in their debt and equity financing. The analysis
shows the effect of the balance sheet’s structure on the company’s earnings.

Basics of EBIT-EPS Approach

It is important to understand what EBIT and EPS mean to understand what the
analysis is meant to be.
  EBIT refers to earnings before interest and tax. The metric makes interest and
taxes irrelevant. Therefore, an investor can understand how the company is
performing out of the balance sheet’s composition which essentially makes
interest and taxes the focal point of consideration. In terms of EBIT, there is
no difference if a company has huge debt or no debt at all. The repercussions
will be the same.
 EPS or earnings per share is the metric that shows a company’s earnings
including interests and taxes. It is an important metric because it shows the
earnings on a per-share basis which helps the investors understand how a
company performs on an overall basis. If a company’s overall profit soars high
but the payment to investors is low, it is a bad gesture for investors owning a
fixed number of shares. EPS shows this dynamic rule simply and in a clear
manner.
The ratio between these two metrics can show how the bottomline results, the
company’s EPS, are related to its performance irrespective of its capital structure,
the EBIT.

Limitations of EBIT-EPS Analysis

Although EBIT-EPS analysis is a good way to check the earning sensitivity of a
company, it has certain limitations too.
No Consideration of Risk 
The EBIT-EPS analysis does not consider the risk associated with a business
project. It simply shows whether the earnings are enough for a corporation. It is not
needed in case of a profit larger than returns, but it can be hurting if the opposite
situation is there. When the profits are low, but the interest is high, then businesses
may be in turmoil.
Contradictory Results
When new equity shares are not considered in a different alternative financial plan,
the results arising out of this can get erroneous. The comparison of plans also
becomes difficult when the number of alternatives increases.
Over-capitalization of Funds
This analysis ignores the over-capitalization of the funds. Beyond a certain point,
additional capital should not be employed to generate a return in excess of the
payments that should be made for its use. The analysis does not address such
cases.

Definition
EBIT-EPS analysis is a technique used to determine the optimal capital structure in which the
value of earnings per share (EPS) has the highest amount for a given amount of earnings before
interest and taxes (EBIT). In other words, the objective of EBIT-EPS analysis is to determine the
effect of using different sources of financing on EPS.
Formula
EBIT-EPS indifference point is an important tool used to choose between two alternative
financing plans. The formula to calculate it is as follows:
(EBIT - IA)(1 - T) - (EBIT - IB)(1 - T) -
PDA  = PDB
SA SB
where:
EBIT – earnings before interest and taxes
I  – interest expense in financing plan A
A

I  – interest expense in financing plan B

B

T – corporate income tax rate

PD  – preferred dividends payable in financing plan A
A

PD  – preferred dividends payable in financing plan B

B

S  – amount of common stock outstanding in financing plan A

A

S  – amount of common stock outstanding in financing plan B

B

The indifference point is the value of EBIT where both financing plans would bring the same
EPS. In other words, there is no difference in the two alternative financing plans.
EBIT-EPS graph
Let’s assume that management of a company is considering two alternative capital structures.
1. Financing plan A with high financial leverage (debt financing)
2. Financing plan B with low financial leverage (equity financing)
The EBIT-EPS graph for both alternative capital structures is given in the figure below.

When EBIT reaches the EBIT-EPS indifference point, both financing plans generate equal EPS.
However, if EBIT has a lower value, equity financing will generate higher EPS than debt
financing. For any value of EBIT to the right of the indifference point, debt financing will give a
higher value of EPS because of a higher degree of financial leverage.
Example
Management of Total S.E. Inc. is considering two alternative financing plans. The detailed
information is given in the table below.
The par value of common stock is $10, preferred stock has $100 par value and 15% dividend,
and long-term debt is presented by 10-year bonds of $1,000 par value and a fixed annual
coupon rate of 8%. The corporate income tax rate is 30%.
The first step of EBIT-EPS analysis is to find the indifference point. Thus, we have to calculate
interest expense and preferred dividends for each financing plan.
I  = $5,000,000 × 8% = $400,000
A

I  = $13,000,000 × 8% = 1,040,000
B

PD  = $3,000,000 × 15% = $450,000

A

PD  = $2,000,000 × 15% = $300,000

B

S  = $15,000,000 ÷ 10 = 1,500,000
A

S  = $8,000,000 ÷ 10 = 800,000
B

Let’s make an equation using the data above.

(EBIT - $400,000)(1 - 0.3) -
$450,000  = (EBIT - $1,040,000)(1 - 0.3) - $300,000
1,500,000 800,000

Having solved this equation, we get an indifference point of $1,955,102, that is, for such a value
of EBIT, each financing plan will give the same earnings per share of $0.4257. The EBIT-EPS
graph is shown below.

If the expected EBIT is lower than $1,955,102, financing plan A will demonstrate a higher EPS.
Otherwise, the capital structure of financing plan B should be preferred.
Advantages and disadvantages of EBIT-EPS analysis
Advantages
1. Financial planning. Applying EBIT-EPS analysis allows earnings per share to be
maximized for any given value of earnings before interest and taxes. It helps to choose
the best financing plan.
2. Comparative analysis. Such analysis is possible not only for a company as a whole but
also for a specific product, project, department, or market.
 3. Determination of target capital structure. Depending on the expected EBIT, management
of a company is able to determine the target capital structure for maximizing EPS.
Disadvantages
1. Risk is not taken into account. EBIT-EPS analysis does not take into account the risks
associated with debt financing. In other words, a higher EPS associated with using
financial leverage implies a higher risk that has to be taken into account by management.
2. Complexity. The more alternative financing plans are considered, the higher the
complexity of the calculations.
3. Limitations. The technique does not account for limitations in raising various sources of
financing.

Traditional Approach to Capital Structure

Definition
The traditional approach to capital structure assumes that an increase in the proportion of debt to
some extent does not result in an increase in the cost of equity, i.e., it remains fixed or grows
slightly. That is the reason why it becomes possible to reduce the weighted average cost of
capital (WACC) by increasing the proportion of debt financing in total capital. Thus, firms using
financial leverage within certain limits are valued higher by the market than similar companies
with lower financial leverage.
Assumptions
The traditional theory of capital structure is based on the following assumptions:
1. Cost of debt (k ) remains stable with an increase in the debt ratio to a certain limit after
d

which it begins to grow.

2. Cost of equity (k ) remains stable or grows slightly with an increase in the debt ratio to a
e

certain limit after which it begins to grow rapidly.

3. Weighted average cost of capital decreases to some degree with an increase in the debt
ratio and then begins to grow.
4. Cost of equity is larger than the cost of debt at any capital structure, i.e., k >k  at any
e d

value of debt ratio.

5. The traditional approach to capital structure believes the existence of optimal capital
structure. It is such a mix of debt and equity at which WACC reaches the minimal value
and the value of a firm will be maximized.
Graphs
Assumptions of the traditional approach to capital structure are illustrated in the figure below.
*financial leverage is measured as a debt ratio
When financial leverage equals to 0, i.e., the capital of a firm is represented by equity only, its
WACC is equal to the cost of equity. As the financial leverage increases, the WACC will
decrease until the marginal cost of debt is lower than the marginal cost of equity. The minimal
value of WACC is reached when the marginal cost of debt equals the marginal cost of equity.
Such a capital structure is considered as optimal under the traditional approach. A further
increase of financial leverage will result in an increase of WACC as far as the marginal cost of
debt will be higher than the marginal cost of equity due to higher risks.
When the optimal capital structure is reached, the value of a firm is maximized as shown in the
figure below.

Examples
Total capital of STAR S.E. Inc. is $3,000,000 and expected earnings before interest and taxes
are $510,000. Management needs to determine the optimal capital structure in which the market
value of a company will be maximized. The information about cost of debt (k ) and cost of equity
d

(k ) at different values of debt ratio is presented in the table below.

e
We should use the formula below to calculate the WACC at different values of debt ratio
WACC = k ×w  + k ×w
d d e e

where w  is the proportion of debt in total capital (debt ratio) and w  is the proportion of equity (1 -
d e

debt ratio).
WACC at D/E of 0 = 12% × 0.00 + 17%×(1-0.00) = 17.00%
WACC at D/E of 0.15 = 12%×0.15 + 17%×(1-0.15) = 16.25%
WACC at D/E of 0.30 = 12%×0.30 + 17%×(1-0.30) = 15.50%
WACC at D/E of 0.40 = 12%×0.40 + 18%×(1-0.40) = 15.60%
WACC at D/E of 0.50 = 14%×0.50 + 21%×(1-0.50) = 17.50%
WACC at D/E of 0.60 = 17%×0.60 + 24.5%×(1-0.60) = 20.00%
WACC at D/E of 0.75 = 22%×0.75 + 30%×(1-0.75) = 24.00%
WACC at D/E of 1.00 = 30%×1.00 + 40%×(1-1.00) = 30.00%
Management of STAR S.E. Inc. may reach the minimum WACC of 15.5% when its capital
structure is represented by 30% of debt and 70% of equity.

Let’s see if the value of STAR S.E. Inc. will be maximized under the traditional approach to
capital structure. To do this, we need to calculate its value (V) for all variants of capital structure
using the following formula:
V=E+D
where E is the current value of equity, and D is the current value of debt.
In turn, the value of equity can be calculated using the equation below
 EBIT -
E I
= 
ke
where I is interest expense.
Let’s calculate the value of STAR S.E. Inc. for all variants of capital structure.
At wd = 0.00
D = $3,000,000 × 0.00 = $0
I = $0
$510,00
E =  0  = $3,000,000
0.17

V = $3,000,000 + $0 = $3,000,000
At wd = 0.15
D = $3,000,000 × 0.15 = $450,000
I = $450,000 × 0.12 = $54,000
($510,000 -
E =  $54,000)  = $2,682,353
0.17

V = $2,682,353 + $450,000 = $3,132,353

At wd = 0.30
D = $3,000,000 × 0.30 = $900,000
I = $900,000 × 0.12 = $108,000
E ($510,000 - $108,000)
 = $2,364,706
=  0.17

V = $2,364,706 + $900,000 = $3,264,706

At wd = 0.40
D = $3,000,000 × 0.40 = $1,200,000
I = $1,200,000 × 0.12 = $144,000
E ($510,000 - $144,000)
 = $2,033,333
=  0.18

V = $2,033,333 + $1,200,000 = $3,233,333

At wd = 0.50
D = $3,000,000 × 0.50 = $1,500,000
I = $1,500,000 × 0.14 = $210,000
E ($510,000 - $210,000)
 = $1,428,571
=  0.21

V = $1,428,571 + $1,500,000 = $2,928,571

At wd = 0.60
D = $3,000,000 × 0.60 = $1,800,000
I = $1,800,000 × 0.17 = $306,000
($510,000 -
E =  $306,000)  = $832,653
0.245

V = $832,653 + $1,800,000 = $2,632,653

At wd = 0.75
D = $3,000,000 × 0.75 = $2,250,000
I = $2,250,000 × 0.22 = $495,000
($510,000 -
E =  $495,000)  = $50,000
0.30

V = $50,000 + $2,250,000 = $2,300,000

The calculations above prove that the value of STAR S.E. Inc. will be maximized at a debt ratio
of 0.30.

Modigliani-Miller Theories of Capital Structure

Definition
The Modigliani-Miller theory of capital structure proposes that the market value of a firm is
irrelevant to its capital structure, i.e., the market value of a levered firm equals the market value
of an unlevered firm if they are within the same class of business risk. This approach believes
there is no optimal capital structure, and that the valuation of the firm depends on its operating
income.
Modigliani-Miller theory without taxes
Assumptions
The Modigliani-Miller theory of capital structure developed in 1958 is based on the following
assumptions:
1. Perfect capital markets
o There are no transactions costs
o There are no flotation costs
o None of the investors can affect the stock price
o Both public and private information are available for any investor
o There are no limitations on buying or selling stock
2. All companies within the same class have the same business risk
3. The cost of borrowing is fixed (k ) and always lower than the required rate of return on
d

equity (k ), i.e., k  < k

e d e

4. All investors have the same estimate of the expected return for each stock
5. Companies distribute all net income to dividends
6. There are no bankruptcy costs
7. There are no taxes
Formula
The Modigliani-Miller theory believes that valuation of a firm is irrelevant to its capital structure.
The equation describing this relationship is as follows:
V  = V
U L

where V  is the market value of an unlevered firm (capital is represented by equity only), and
U

V  is the market value of a levered firm (capital is represented by a mix of debt and equity).
L

Thus, the market value of a firm depends on the operating income and business risk rather than
its capital structure. Therefore, the market value of an unlevered firm can be calculated using the
following formula:
EBI
VU = T
VL = 
ke0
where EBIT is earnings before interest and taxes, and k  is the required rate of return on equity
e0

of an unlevered firm.
The Modigliani-Miller theory of capital structure also believes that the weighted average cost of
capital (WACC) is fixed at any level of financial leverage and equals the required rate of return on
equity of an unlevered firm (k ).
e0

WACC = ke0
Graph
Assumptions of the Modigliani-Miller theory without taxes are presented in the figure below.

*Debt ratio is used to measure financial leverage

Modigliani and Miller suggest that the weighted average cost of capital remains fixed because
the risk is growing by an increase in financial leverage, and investors will claim a higher return to
compensate for it. In other words, the required rate of return on equity will increase as financial
leverage increases. Therefore, increasing cheaper debt will be offset by a higher required rate of
return on equity. This relationship is described by the following equation:
keL = D
 (keU - kD)
keU +  E
where k  is the required rate of return on equity of a levered firm, k  is the required rate of return
eL eU

on equity of an unlevered firm, D is the market value of debt, E is the market value of equity, and
k  is the required rate of return on debt.
D

Another proof of the Modigliani-Miller theory of capital structure is arbitrage, i.e., simultaneous
buying and selling of shares with the same business risk but with different prices. In this case,
investors will sell overvalued stock and buy undervalued stock; therefore, the price of overvalued
stock will decline, and the price of undervalued stock will increase until they are equal, i.e., until
the moment when market equilibrium will occur. When the market reaches equilibrium, arbitrage
becomes impossible. Therefore, the market value of firms within the same class of business risk
will be the same regardless of their capital structure.
Example
Let’s assume that earnings before interest and taxes of Total S.E. Inc. is $1,200,000 and the
required rate of return on equity for unlevered firms within the same class of business risk is
24%.
The market value of Total S.E. Inc. can be calculated as follows:
V=E+D
The formula used to calculate the required rate of return on equity is as follows:
EBIT -
k  = I
e

E
The weighted average cost of capital can be calculated as shown below
WACC = k w  + k wd d e e

where w  is the proportion of equity (debt ratio), and w  is the proportion of equity.
d e

Let’s calculate the market value of Total S.E. Inc. for each capital structure given in the table
above.
At w  = 0.00
d

The market value of an unlevered firm is equal to the market value of its equity.
$1,200,00
V = E =  0  = $5,000,000
0.24

WACC = 12% × 0.00 + 24% × (1.00 - 0.00) = 24%

At w  = 0.20
d

D = $5,000,000 × 0.20 = $1,000,000

E = $5,000,000 - $1,000,000 = $4,000,000
I = $1,000,000 × 12% = $120,000
($1,200,000 -
k  = 
e
$120,000)  = 27%
$4,000,000

V = $4,000,000 + $1,000,000 = $5,000,000

WACC = 12% × 0.20 + 27% × (1.00 - 0.20) = 24%
At w  = 0.40
d

D = $5,000,000 × 0.40 = $2,000,000

E = $5,000,000 - $2,000,000 = $3,000,000
I = $2,000,000 × 12% = $240,000
($1,200,000 -
k  = 
e
$240,000)  = 32%
$3,000,000

V = $3,000,000 + $2,000,000 = $5,000,000

WACC = 12% × 0.40 + 32% × (1.00 - 0.40) = 24%
At w  = 0.60
d

D = $5,000,000 × 0.60 = $3,000,000

E = $5,000,000 - $3,000,000 = $2,000,000
I = $3,000,000 × 12% = $360,000
($1,200,000 -
k  = 
e
$360,000)  = 42%
$2,000,000

V = $2,000,000 + $3,000,000 = $5,000,000

WACC = 12% × 0.60 + 42% × (1.00 - 0.60) = 24%
At w  = 0.80
d

D = $5,000,000 × 0.80 = $4,000,000

E = $5,000,000 - $4,000,000 = $1,000,000
I = $4,000,000 × 12% = $480,000
($1,200,000 -
k  = 
e
$480,000)  = 72%
$1,000,000

V = $1,000,000 + $4,000,000 = $5,000,000

WACC = 12% × 0.80 + 72% × (1.00 - 0.80) = 24%
The example above illustrates the Modigliani-Miller theorem. As we can see, the required rate of
return on equity increases as the proportion of debt increases. Therefore, the weighted average
cost of capital and market value of a firm is irrelevant to its capital structure. We can also see that
the market value of an unlevered firm equals the market value of a levered firm.
Modigliani-Miller theory of capital structure with taxes
The theory was further developed by its authors in 1963 by excluding the no taxation
assumption.
The main point of the improved theory of capital structure is the hypothesis that valuation of a
levered firm will be higher than the valuation of an unlevered firm within the same class of
business risk. The reason is that interest expense is an allowable deduction from taxable income;
thus, levered firms have a tax shield.
Formula
The equation describing the relationship between the market value of a levered and an
unlevered firm is as follows:
V  = V  + T×D
L U

where T is the corporate tax rate, and D is the market value of debt.
In other words, the market value of a levered firm exceeds the market value of an unlevered firm
by the amount of tax shield (T×D), assuming the debt is perpetual.
Graph
The propositions of the Modigliani-Miller theory of capital structure without taxes are illustrated in
the figure below.
*Debt ratio is used to measure financial leverage
As far as the cost of debt is actually lower by the amount of tax shield, an increase in its
proportion results in a decrease in the weighted average cost of capital. This relationship can be
described by the following equation:
keL = D
 (keU - kD)(1 - T)
keU +  E
Thus, optimal capital structure exists when the capital of a firm is represented by debt only!
Therefore, firms should replace equity by cheaper debt to reduce their WACC and maximize
market value.
Income tax on capital owners
In 1978, the Modigliani-Miller theory of capital structure was further developed by taking into
account the income tax on capital owners. The new hypothesis proposed that investor behavior
depends on tax preference. The idea behind it is that dividends, capital gains, and interest
income are usually taxed at different rates, which suggests that investor behavior is relevant to
tax preference.
The equation describing the relationship between the market value of a levered and an
unlevered firm is as follows:
VL = VU + D (1 (1 - T)(1 - te)
)
-  (1 - td)
where t  is the income tax rate of shareholders, and t  is the income tax rate of debtholders.
e d

Criticism
The Modigliani-Miller theory of capital structure was criticized because the assumption that
capital markets are perfect is completely unrealistic. The arbitrage, as proof of the Modigliani-
Miller theory, was also strongly criticized. If there are no perfect capital markets, the arbitrage will
be useless because a levered and an unlevered firm within the same class of business risk will
have different market values.
The reasons why arbitrage does not allow market equilibrium in real life are as follows:
1. Transaction costs. If there are transactions costs, buying stock will require bigger initial
investments, but the return remains the same. Therefore, the market value of a levered
firm will be higher than an unlevered one, assuming that both of them are within the
same class of business risk.
2. The cost of borrowing is not the same for individuals and firms . The cost of borrowing
depends on the individual credit rating of the borrower.
3. Institutional constraints. Institutional investors slow down arbitrage because they limit the
use of financial leverage by their clients.
4. Bankruptcy cost. The higher the financial leverage, the higher is the probability of
bankruptcy. Therefore, bankruptcy costs have a strong influence on firms.
Many critics of the Modigliani-Miller theory of capital structure believe that assumptions are
unrealistic and that the market value of a firm as well as WACC depends on financial leverage.

Net Operating Income Approach of Capital

Structure
Definition
The net operating income approach claims that valuation of a firm is irrelevant to capital
structure. In other words, the market value of a firm will be the same regardless of the proportion
of debt. The reason is that any benefit from the increase of cheaper debt will be offset by a
higher required rate of return on equity. Thus, the weighted average cost of capital (WACC) and
the market value of a firm remain fixed at any level of financial leverage. In turn, the market value
of a firm depends on earnings before interest and taxes and the weighted average cost of
capital.
Assumptions
The net operating income approach works best if the following assumptions are met:
1. The weighted average cost of capital is constant and irrelevant to capital structure
2. The valuation of a firm is determined by operating income and WACC
3. The cost of debt (k ) is constant at any level of financial leverage
d

4. The cost of equity (k ) is larger than the cost of debt at any level of financial leverage, i.e.,
e

k  > k
e d

Formula
As has been mentioned before, the market value of a firm (V) depends on operating income
(earnings before interest and taxes, EBIT) and WACC.
EBIT
V
=  WAC
C
Please note that if assumptions are met, both EBIT and WACC are irrelevant to capital structure.
The market value of shareholders’ equity (E) is calculated as the market value of a firm less the
market value of debt (D).
E=V-D
As far as the cost of debt is constant, the formula to calculate the required rate of return on equity
(cost of equity) is as follows:
EBIT -
k  I
e

Graph
The main proposition of the net operating income approach of capital structure is the constant
weighted average cost of capital at any level of financial leverage. In other words, the mix of debt
and equity is irrelevant to the market value of a firm.
The reason why replacing equity by cheaper debt will not result in a decrease of WACC is that
risk increases as financial leverage increases. Thus, investors will claim a higher required rate of
return on equity to compensate for the higher risk they take. Therefore, using higher financial
leverage will be offset by an increase in the cost of equity; consequently, the WACC remains
constant at any mix of debt and equity.
We should also note that an increase in financial leverage results in a decrease of the price-
earnings ratio (P/E).
*The graph illustrating the net operating income approach of capital structure will be slightly different
depending on whether a debt-to-equity ratio or a debt ratio is used as a measure of financial leverage.
Example
Total S.E. Inc. has declared earnings before interest and taxes of $360,000, and the book value
of total capital is $2,500,000. The cost of borrowing is 8%.

Let’s calculate the cost of equity at different levels of financial leverage.

At debt ratio of 0.00
Equity = $2,500,000 × (1-0.00) = $2,500,000
Debt = $2,500,000 × 0.00 = $0
I = $0 × 8% = $0
$360,00
V =  0  = $3,000,000
0.12

E = $3,000,000 - $0 = $3,000,000
($360,000 - $0)
k  = 
e  = 12.0%
$3,000,000

At debt ratio of 0.25

Equity = $2,500,000 × (1-0.75) = $1,875,000
Debt = $2,500,000 × 0.25 = $625,000
I = $625,000 × 8% = $50,000
$360,00
V =  0  = $3,000,000
0.12

E = $3,000,000 - $625,000 = $2,375,000

($360,000 -
k  = 
e
$50,000)  = 13.1%
$2,375,000

At debt ratio of 0.50

Equity = $2,500,000 × (1-0.50) = $1,250,000
Debt = $2,500,000 × 0.50 = $1,250,000
I = $1,250,000 × 8% = $100,000
$360,00
V =  0  = $3,000,000
0.12
E = $3,000,000 - $1,250,000 = $1,750,000
($360,000 - $100,000)
k  = 
e  = 14.9%
$1,750,000

At debt ratio of 0.75

Equity = $2,500,000 × (1-0.75) = $625,000
Debt = $2,500,000 × 0.75 = $1,875,000
I = $1,875,000 × 8% = $150,000
$360,00
V =  0  = $3,000,000
0.12

E = $3,000,000 - $1,875,000 = $1,125,000

($360,000 - $150,000)
k  = 
e  = 18.7%
$1,125,000

At debt ratio of 1.00

Equity = $2,500,000 × (1-1.00) = $0
Debt = $2,500,000 × 1.00 = $2,500,000
I = $2,500,000 × 8% = $150,000
$360,00
V =  0  = $3,000,000
0.12

E = $3,000,000 - $2,500,000 = $500,000

($360,000 - $200,000)
k  = 
e  = 32.0%
$500,000

As we can see, the market value of a firm and WACC are definitely constant at any level of
financial leverage under the net operating income approach of capital structure. However, the
cost of equity (required rate of return for investors) grows as financial leverage increases.