Financial Management

Unit III
Financing Decisions
Financial Leverage, Operating leverage,
combined leverage meaning, measures, financial
leverage and share holders risk & return, EBIT,
EPS analysis, Capital structure , relevance &
Irrelevance theories of capital structure 0 NI,
NOI, MM approach
 Introduction
Capital structure determines the types of fund a firm seeks to finance
its investment opportunity and the proposition in which these funds
should be raised. If the propositions of own capital is more than debt
capital, the return and risk of the shareholders will be much less.
• The leverage analysis is the technique used by business firm to
quantify risk-return relationship of different alternative capital
structure.
• In finance leverage is used to describe the firms ability to use fixed
cost assets and funds to magnify the return to its owners.
• When volume of sales changes, leverage helps in increasing the
firms profit. A high degree of leverage implies that there will be a
large change in profit as result of relatively small changes in sales
and vice versa
Types of leverage
- Operating leverage
- Financial leverage
- Combined Leverage
 Operating leverage
Operating leverage implies use of fixed cost in the operating firm. Every
firm has tin incur fixed cost irrespective of volume of production or
sales. Since fixed cost remains constant, even a small change is sales
brings about a more than propionate change in operating profit.
The firm’s ability to use fixed operating cost to magnify the
effect of changes in sales on its earnings before interest and tax.

Degree of Operating Leverage

Degree of operating leverage depends upon the amount of fixed cost
element in the cost structure. A firm is said to have a high degree of
operating leverage it if employs a greater amount of fixed cost and a
smaller amount of variable cost.
 • Operating leverage tell the impact of changes in sales in operating
income.
• Firm having higher DOL can experience a magnified effect on EBIT
for even a small changes in sales level.
• Higher DOL can increases operating profit, but if there is decline in
sales, EBIT may be wiped out & loss may be occurred
• Operating leverage depends on fixed cost, if fixed cost is higher
firms operating leverage and operating risk will be higher
Financial Leverage
Financial Leverage occurs when a firm uses more fixed interest /
dividend bearing securities i.e debentures and preference share, along
with equity to improve return on equity.
• Firm fixed financial charges will not vary with operating profit.
• The reaming EBIT, after paying fixed charges belongs to equity
shareholders.
• Financial leverage is concerned with the effect of changes in EBIT on
earnings available to equity share holders (EPS).
• Firms ability of firm to use fixed financial charges to magnify the
effect of changes in EBIT on the firm’s EPS.

Degree of Financial Leverage (DFL)

Degree of financial leverage(DFL) is the percentage changes in taxable
profit as a result of percentage changes in operating profit.
• It explains the ability of the firm to utilize fixed financial cost in order
to magnify the effect of changes in EBIT on EPS of the firm. DFL
computed by

• Financial Leverage is favorable when the firm earns more on the

investment/ assets financed by sources having fixed charges.
• Shareholder gain in a situation where firm earns a high rate of return
and pay a lower gain on a situation where the firm earns a high rate
of return and pays a lower rate of return tp supplier of long term
funds
• Financial leverage helps to plan appropriate capital structure, and
maximize the ROE & EPS.
• Higher Fin. Leverage higher financial cost and higher financial
risk,.
Combined leverage
Both Operating leverage and financial leverage closely concerned
with firm’s capacity to meet its fixed cost. If both this leverages are
combined, the result obtained will reveal the effect of changes in
sales over changes in taxable profit or EPS

• Combined leverage establishes relationship between sales and

corresponding variation in taxable income.
• Combined leverage shows combined effect of financial and operating
leverages.
• A high operating leverage and high financial leverage combines very
risky, if firm is producing and selling at high level, it will make
extremely high profit for its shareholders. But even a small fall in the
level of operations, would result in a tremendous fall in EPS.
• High operating leverage and low financial leverage indicate that the
management is careful since higher amount of risk involved in high
operating leverage has been sought to be balanced by low financial
leverage.
• More preferable situation would be to have a low operating leverage
and high financial leverage. As low operating leverage would
automatically imply that the firm reaches its break-even point at a low
level of sales.
 Financial Leverage and shareholders return
Primary motive of firm in using fin. Leverage is to magnify shareholders
return under favorable economic condition.
• Its based in the assumption that fixed charges funds can be
obtained at a lower cost than firms required rate of return.
• When difference between earnings generated by assets financed by
the fixed-charges funds and cost of these funds is distributed to the
shareholders by which EPS & ROE increases.
• EPS & ROE will fall if the company obtains fixed charges funs at a
higher cost thane required rate of return. Thus EPS, ROE & ROI are
influenced by financial leverage.
Interest tax shield
The effect of debt is to see the impact of the interest charges on the
firm’s tax liability. The interest charges are tax deductible and
therefore, provided tax shield which increases the earnings of the
shareholder.
Financial leverage magnifies the shareholders earnings. Variability of
EBIT causes EPS to fluctuate within the wider ranges with debt in the
capital structure. With more debt EPS raises and falls faster than the
rise and fall in EBIT. Thus financial leverage not inly magnifies EPS but
also increases its variability.
Variability of EBIT and EPS distinguish between two types of risk
- Operating risk
- Financial Risk
Operating Risk can be defined as the variability of EBIT (return on
total asset). The environment internal or external in which a firm
operates determines the variability of EBIT. Operating risk is an
unavoidable risk. A firm is better placed to face such risk if it can
predit it with a fair degree of accuracy. Variability of EBIT has two
components Variability in sales & Variability in expenses
Financial Risk
For a given degree of variability of EBIT, the variability of EPS( &
ROE) increases with more financial leverage. The variability of EPS
caused by the use of financial leverage is called financial risk
 Financial Risk
For a given degree of variability of EBIT, the variability of EPS( &
ROE) increases with more financial leverage. The variability of EPS
caused by the use of financial leverage is called financial risk
 Theories of Capital structure
The objectives of a firm should be directed towards the maximization
of the value of the firm. The capital structure decision should be
examined from the point of view of its impact on the value of the
firm. If the value of the firm can be affected by capital structure or
financing decisions, a firm would like to have a capital structure which
maximize the market value of firm.
Approaches
(i) Net Income(NI) approach
(ii) Net Operating income approach
(iii) Traditional approach
(iv) Modigliani and Miller approach
These approached analyze the relationship between the leverage,
cost of capital and value of firm in different ways.
 Assumptions for capital structure theories
(i) There are two sources of finance debt & equity
(ii) Total asset of the firm and its capital employees are constant.
However, debt & equity mix can be changes either by
borrowing to repurchase equity or raising equity to repay debt.
(iii) All residual earnings are distributed to equity shareholders
(iv) The firm earns operating profit and it is expected to grow.
(v) The business risk is assumed to be constant and is not affected
by the financing mix decisions ( No changes in fixed cost or
operating risks)
(vi) There are no corporate or personal taxes
(vii) The investor have the same subjective probability distribution
of expected earnings (No difference in investor expectations)
(viii) Cost of debt (Kd) is less than cost of equity (Ke)
 Net Income Approach
This approach has been suggested by Durand. According to this approach, a firm
can increase its value or lower the overall cost of capital by increasing the
proportion of debt in the capital structure. i.e. If the degree of financial leverage
increases, the weighted average cost of capital will decline with every increase in
the debt content in total capital employed, while the value of firm will increase.
Reserve will happen in a converse situation.
Assumption
(i) No Corporate taxes
(ii) Cost of debt (Kd) is less than cost of equity (Ke)
(iii) The use of debt content does not change the risk perception of investors. As
result both the Kd and Ke remain constant.
the total market value of firm (V) under the NI approach is determined with the
help of the following formula
V=S+D V= Total mkt value ; S= Mkt Value equity share ;
D= Mkt value of debt
 Net Operating Income approach
The approach has been suggested by Durand. According to this approach,
the mkt value of the firm is not affected by the captial structure changes.
The market value of the firm is ascertained by capitalizing the net
operating income at the overall cost of capital which is constant. The Mkt
value of the firm is determined as follows

Assumptions
(i) The overall cost of capital remains constant for all degree of debt-
equity mix
(ii) The market capitalizes the value of firm as a whole. Thus split
between debt equity is not important
(iii) The use of less costly debt funds increases the risk of shareholders.
This causes the equity capitalization rate to increase. Thus the
advantage of debt is set off exactly capitalization rate.
(iv) There are no corporate taxes
(v) The cost of debt is constant
Traditional Approach: This approach is also known as intermediate
approach as it takes a midway between NI & NOI. According to this
approach the use of debt up to a point is advantageous. It can help to
reduce the overall cost of capital and increase the value of the firm,
beyond this point, the debt increases the financial risk of shareholders. As
a result, cost of equity also increases, the benefit of debt is neutralized by
the increased cost of equity. Thus up to a point, the content of debt in
capital structure will be favorable. Beyond that point the use of debt will
adversely affect the value of the firm. At the point the capital structure is
optimal and the overall cost of capital will be the least.

Modigliani and Miller approach: Modigliani and Miller have explained

the relationship between cost of capital, capital structure and total value
of the form under two conditions
(a) When there are no corporate tax
(b) When there are corporate tax
When there are NO Corporate tax : the MM, approach is identical to NOI
approach, when there are no corporate taxes. MM argues that in the
absence of taxes the cost of capital and value of the form are not affected
by capital structure or debt equity mix. They gave a simple argument in
support of their approach.
- According to traditional approach, cost of capital is the weighted
average of cost of debt and cost of equity etc. The cost of equity, they
argued, is determined by level of shareholders expectations Now if
shareholder expect 15% from a particular firm, they do take into
account the debt-equity ratio and they expect 15% merely because
cover particular risk which the firm entails. If debt increases further the
risk of the firm as it is risky finance. Thus share holder will expect a
higher return. Thus the change in debt equity mix is automatically
offset t=by a change in the expectation of the shareholders.
- MM argues that financial leverage has noting to do with the overall
cost of capital and the overall cost of capital is equal to the
capitalization rate of pure equity stream of its class of risk.
MM make following proposition
(a) The total Mkt value of a firm & its coat of capital are independent
of tis capital structure. The total market value of firm is given by
capitalizing the expected stream of operating earnings at a discount
rate considered appropriate for its risk class
(b) The cost of (Ke) is equal to capitalization rate of purely equity
stream plus a premium for financial risk. The fin risk increases ina
manner to offset exactly the use of less expensive source of funds
(c) The cut of rate for investment purpose is complete independent of
the way in which the investment is financed
Assumptions
(a) Capital Mkt are perfect. Investor are free to buy and sell securities.
They are well informed about risk-return on all type of securities.
No transaction cost. The investor behave rationally. They can
borrow without restrictions on the same terms as the firms do.
(b) The firms can be classified into homogenous risk classes. All firms
with in the same class will have the same degree of business risk.
(c) All investor have the same expectations from firm’s net operating
income EBIT which are necessary to evaluate the value of the firm
Arbitrage process MM hypothesis reveals that the total value of firm
is determined by its operating income or EBIT. It is independent of
the debt equity mix. Two firm which are identical in all aspects
expect their capital structure cannot have different market value or
different cost of capital. If the market value of the firm differ,
arbitrage process will take place and make them equal.
II. When there are corporate tax :
MM agreed that the capital structure will affect the value of the firm
and the cost of capital when taxes are applicable to corporate
income. If a firm uses debt in its capital structure, the cost of capital
will decline and market value of the firm will increase. This because
interest is detectable expenses for tax purpose and therefore, the
effective cost od debt is less than the contractual rate of interest. A
levered firm can therefore have more earnings to its equity
shareholder than an unlevered firm. This make debt financing
advantageous and value of the levered firm will be higher that of an
unlevered firm.