Chapter 9

Capital Structure and Leverage

 Business and Financial Risk
Breakeven point: The sales volume at which total
revenue is equal to total cost
 Revenue Sales Revenue
& Cost FC + VC

FC

Sales
Volume
Break Even Point

2 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Breakeven point
Computation:
BEP = FC / (ppu-vpu) or BEP = FC / Unit CM

Choice Issue: High Fixed – Low Variable Cost

VS
High Variable Cost – Low Fixed Cost
 Impact on Contribution Margin
Business Risk
3 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020
 Business Risk Evaluation
SR & Cost SR FC + VC

Fc + VC (High
Fixed, Low Var)

FC

Sales
Volume
Break Even Point

4 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Operating Leverage
Computation:
Operating Leverage at Level x
OLx = % change in EBIT/% change in sales.
= (p-v) sales/ [ (p-v) sales – FC]

Interpretation:
for every 1% change in sales, the firm can expect a
percent change in its EBIT equal to the multiple of OL. (By
how much EBIT is magnified due to 1 % change iN Sales)
5 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020
 Operating Leverage: Example

Number of Units Sold 10,00011,000

Sales Revenue Taka 20,00,00,000 Taka 22,00,00,000
Variable Cost 12,00,00,000 13,20,00,000
Gross Profit 8,00,00,000 8,80,00,000
Fixed Cost 5,00,00,000 5,00,00,000
EBIT 3,00,00,000 3,80,00,000

OL = Percent Change in EBIT (at given level)/Percent change in Sales.

= [3,80,00,000-3,00,00,000)/3,00,00,000]/
[(22,00,00,000-20,00,00,000)/20,00,00,000] = .2667/.10 = 2.67
1% change in Sales magnifies EBIT by 2.67%

6 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Financial Leverage
The percent change in EPS (earnings per
share) as a result of a percent change in
EBIT (earnings before interest and taxes).

Degree of Financial Leverage at Level x

DFLx = % change in EPS/% change is EBIT
= [(p-v) sales – FC]/ [ (p-v) sales – FC-
Interest]
7 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020
 Impact of Financial Leverage on Business Risk
 Sales Revenue
 Cost and Rev
 FC + VC + Int
 FC + VC


 FC

 Sales Rev
 BEP BEP

8 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Financial Leverage: Example
 Number of Units Sold 10,000 11,000
 Sales Revenue Taka 20,00,00,000 Taka 22,00,00,000
 Variable Cost 12,00,00,000 13,20,00,000
 Gross Profit 8,00,00,000 8,80,00,000
 Fixed Cost 5,00,00,000 5,00,00,000
 EBIT 3,00,00,000 3,80,00,000
 Interest 1,00,00,000 1,00,00,000
 Earnings before Taxes 2,00,00,000 2,80,00,000
 Taxes 60,00,000 84,00,000
 Earnings after Taxes 1,40,00,000 1,96,00,000
 Number of shares outstanding 20,00,000
20,00,000
 EPS Taka 7 Taka 9.8
 Financial Leverage = DFL = % Change in EPS/%Change in EBIT = .
4/.2667 = 1.5

9 Interpretation?
Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020
 Total Leverage
(Degree of) Total Leverage
DTLx = % change in EPS/% change in sales.
 = DOLx * DFlx

10 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Optimal Capital Structure
Cost of Debt and Equity Cost of equity

WACC

Cost of Debt

D/S
D/S*

11 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Is There Really an Optimal Capital Structure?
Irrelevance Theory by Modigliani & Miller

No Tax Arbitrage causes Vu = Vl

Presence of Corporate Tax
 Value Vl = Vu + PV of Tax shield

 Vu

 D/S

12 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Why are Firms not Fully Levered?
Pecking Order Theory
Agency Cost
Financial Distress and Bankruptcy Cost
Signaling Hypothesis

13 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Optimal Capital Structure, Graphically
 Cost of Capital
 Vl

 Vl – PV of
Costs

 Vu


 D/Sopt
D/S

14 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 EBIT-EPS Indifference Point for New Capital Issue
Point at which the EPS will be the same regardless of the competing
financing plans under consideration.
Solve for EBIT for the following equation

(EBIT – I1)(1-t) – PD1 = (EBIT – I2)(1-t) – PD2

 S1 S2
Where
t = tax rate
PD1 and PD2 are the preferred dividends under the two plans
S1 and S2 are number of shares outstanding after financing for plan
1 and plan 2 respectively.
 

15 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 COMPUTING EBIT-EPS TRADE-OFF
Solve for EBIT for the following equation

(EBIT – I3)(1-t) – PD3 = (EBIT – I4)(1-t) – PD4

 S 3 S4
[(EBIT – 60,00,000)(1-t) – 0]/300000 = [(EBIT
– 60,00,000)(1-t) – 2600000]/200000

EBIT = 1,71,42,857

16 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Procedure of determining EBIT-EPS Indifference
Point
Define the Two Plans.
Specify the Capital structure of the Two
Plans
• Plan 1(Before) Plan1 (After)
Number of shares
Interest Cost on Bonds/Debt
• Plan 2(Before)
Plan12(After)
Number of shares
Interest Cost on Bonds/Debt
Sharif N. Ahkam, Professor of Finance,
17 North South University 05/14/2020
EBIT-EPS TRADE-OFF-EXCEL
Excel File
 EBIT-EPS TRADE-OFF: GRAPHICALLY
EBIT-EPS TRADE-OFF
40

35

30

25 plan 1
plan 2
EPS

20
plan 3
15 plan 4

10

0
10000000 15000000 20000000

EBIT

19 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Estimating Debt Capacity
Factors Affecting Debt Capacity
• Quality of Assets
• Quality of revenue
• Debt/Equity Ratio (Target)
• Times Interest Earned Ratio (Target)
• Fixed Charge Coverage ratio

21 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Estimating Debt Capacity: Example
Target Debt/Total Capital Ratio : 25%
Target Current Ratio: 1.8
Target TIE Ratio: 6
Current Balance Sheet
Current Assets: 30,000
Current Liabilities 15,000
Long-Term Debt 10,000
Net Worth 30,000
The firm needs to raise 10,000 in new long-term capital for new
projects. Expected EBIT is Taka 8000. Current interest cost is
1,200. New Debt will require 14 percent yield. What is the
Excess Debt Capacity?

22 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Estimating Debt Capacity: Solution
Current Ratio Test:
 Maximum Current Liability Allowed: CA/1.8 = 16,667
 Existing Current Liability 15,000
 Available Slack: 1,667
Debt Ratio Test: (Assuming no short term loan Taken)
Total Capital (Including New Issue): 50,000
Maximum L.T. Debt Allowed: 12,500
Current Long-Term Debt: 10,000
Available Capacity: 2,500
TIE Test
Maximum Interest payment Allowed: EBIT/6 = 8,000/6 = 1,333
Current Interest Payment: 1,200
Capacity to absorb additional interest payment: 133
At 14%, Maximum Debt capacity: 950
Answer: Excess Debt Capacity: 950 (Lower of Debt Ratio Test and TIE Test).

23 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Possible Plans to Raise 10,000
Alternative 1:
Issue L. T. Debt: Taka 950 at 14%
Issue Stock: Taka 9,050
At Taka 20 per share, we will issue 453 new shares. (
Allowance for issuance cost)
Alternative 2:
Take Short-term Loans: Taka 1,500
Issue L. T. Debt: Taka 800 at 14%
Issue Stock: Taka 7,700
At Taka 20 per share, we will issue 385 new shares.
(Allowance for issuance cost)

24 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Lease Versus Buy
Operating Lease
Provides financing and maintenance
Not fully amortized.
Possible option to buy at a stated price at the
end of lease
Possible early cancellation

26 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Lease Versus Buy
Capital Lease
They do not provide for maintenance
Financial leases are not cancelable
They are fully amortized
The lessor is not the owner of the equipment
at the beginning. Only after the lease
agreement is signed, the lessor buys the
equipment from a manufacturer and leases it
to the user under the agreement.
27 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020
 Lease Versus Buy
Example
Firm X decides to acquire an equipment that has a 4 year life and costs Taka
80,00,000 delivered and installed. The equipment can be written off
according to the accelerated depreciation chart of the NBR, 50 percent can be
written off in the first year, 30 percent in the second year, and 20 percent in
the third year. Annual maintenance cost is Taka 12,00,000.
X is considering two options for financing the equipment. (1) X can borrow an
equivalent amount at 12 percent per year for 4 years. The loan will be
amortized over 4 years. (2) X will lease the equipment for 4 years at a rental
charge of Taka 22.40 Lac per year, payable at the end of each year. X has the
option to buy the equipment at the end of the 4 th year for Taka 10 Lac. Lessor
will maintain the equipment. The equipment will be used for at least 4 years.
Do a lease versus buy analysis using 12 percent as the discount rate.
Marginal tax rate is 30 percent.

28 Sharif N. Ahkam, Professor of Finance, North South University 05/14/2020

 Lease Versus Buy Year 1 Year 2 Year 3 Year 4

Borrow and Buy Taka Taka Taka Taka

1. Loan Payment 26,33,875 26,33,875 26,33,875 26,33,875

2. Tax Savings on Interest1 (2,88,000) (2,27,740) (1,60,250) (84,660)

3. Depreciation Tax Savings2 (12,00,000) (7,20,000) (4,80,000) 0

4. Maintenance after Tax 8,40,000 8,40,000 8,40,000 8,40,000

Total Cash Outflow for Buy 19,85,875 25,26,135 28,33,625 33,89,215

Decision
Present Value of Outflows= Taka
79,57,748
Lease

(1) Lease Cost after Taxes 15,68,000 15,68,000 15,68,000 15,68,000

2. Purchase Option 10,00,000

Total Cash Outflow for Lease 15,68,000 15,68,000 15,68,000 25,68,000

Decision
Present Value of Outflows = Taka
53,98,082
Leasing has a net advantage of Taka 25,59,665 over borrowing and purchasing.

1. Interest payments according amortization table are Taka 960,000, 759,135, 534,166,
and 282,201, respectively.
29 2. First year
Sharif depreciation
N. Ahkam, is Taka
Professor of Finance, 40,00,000.
North South UniversitySecond year depreciation is Taka05/14/2020
24,00,000. Third year depreciation is Taka 16.00,000