Capital Structure

 Leverage Issues
 Optimal capital structure
 Operating leverage
 Capital structure theory

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Cost Of Capital ( Theoretical)
 It is the discount rate that that would
be used to determine the PV of a
series of future cash flows
 The minimum rate of return that must
be earned by the firm on its investment
so that its market value remains
unchanged

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 The Concept of Leverage
You cannot easily move a large boulder.

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The Concept of Leverage
However, with the aid of a lever you can
move an object many times your size.

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 What is business risk?
 Uncertainty about future operating income
(EBIT), i.e., how well can we predict operating
income? Probability
Low risk

High risk

0 E(EBIT) EBIT
 Note that business risk does not include
financing effects.
Business risk is affected
primarily by:

 Uncertainty about demand (sales).

 Uncertainty about output prices.
 Uncertainty about costs.
 Product, other types of liability.
 Operating leverage.
What is operating leverage, and
how does it affect a firm’s
business risk?
 Operating leverage is the use of fixed
costs rather than variable costs.
 If most costs are fixed, hence do not
decline when demand falls, then the
firm has high operating leverage.
 More operating leverage leads to more
business risk, for then a small sales
decline causes a big profit decline.

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What is financial leverage?
Financial risk?

 Financial leverage is the use of debt and

stock.
 Financial risk is the additional risk
concentrated on common stockholders as
a result of financial leverage.

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The Concept of Leverage
 In a financial context, the magnifying power
of leverage can be used to help (or hurt) a
firm’s financial performance.
 Operating leverage occurs due to fixed
costs in the production process.
 With high fixed operating costs, a small
change in sales will trigger a large change
in operating income (EBIT).

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Operating Leverage

 Measurement of Operating Leverage

 Degree of Operating Leverage (DOL)

% Change in EBIT
DOL =
% Change in Sales

 DOL > 1 means the firm has operating

leverage.

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 Operating Leverage

Example: fixed costs = Rs1 and variable costs=0

EBIT for Sales of Rs3 = Rs3 - Rs1 = Rs2
EBIT for Sales of Rs4 = Rs4 - Rs1 = Rs3

% Change in EBIT
DOL =
% Change in Sales

(Rs3 - Rs2)/Rs2 .50

DOL = = = 1.5
(Rs4 - Rs3)/Rs3 .33
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DOL
 DOL = Contrb/ EBIT

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 Operating Leverage
 Measurement of DOL
 Calculation using alternate formula:

DOL = Sales - Total VC

Sales -Total VC - FC

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 Operating Leverage
 Measurement of DOL
 Calculation using alternate formula:

DOL = Sales - Total VC

Sales -Total VC - FC

DOL = (Rs3 - Rs0) / (Rs3 - Rs0 -

Rs1) = 1.5

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 Operating Leverage
 Measurement of DOL
 Calculation using per unit information:

DOL = Sales - Total VC

Sales -Total VC - FC

Example: Q = 3,750 units

SP = Rs 800 per unit
VC = Rs 400 per unit
FC = Rs 1,000,000 per
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 Operating Leverage
 Measurement of DOL
 Calculation using per unit information:

DOL = Sales - Total VC

Sales-Total VC - FC

DOL3,750 units = 3,750(800) – 3,750(400)

3,750(800) –3,750(400) – 1,000,000
Interpretation:
Interpretation:IfIfsales
saleschange
change1%,
1%,then
then
= 3 EBIT
EBITwill
willchange
change3% 3%(same
(samedirection).
direction).
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What is financial leverage?
Financial risk?

 Financial leverage is the use of debt in

place of equity
 Financial risk is the additional risk
concentrated on common stockholders
as a result of financial leverage.

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Financial Leverage

 Finance a portion of the firm’s assets with

securities that have fixed financial costs
 Debt

 Preferred Stock

The balance portion being equity shares

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 Financial leverage ratio definition
and explanation:
  
 The financial leverage ratio is also
referred to as the debt to equity
ratio.

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 The financial leverage ratio indicates the
extent to which the business relies on debt
financing.
 Upper acceptable limit of the financial
leverage ratio is usually 2:1, with no more
than one-third of debt in long term.
 A high financial leverage ratio indicates
possible difficulty in paying interest and
principal while obtaining more funding.
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 What Does Degree Of Financial
Leverage - DFL Mean?
A leverage ratio summarizing the
affect a particular amount of financial
leverage has on a company's earnings
per share (EPS).

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 Financial leverage involves using fixed
costs to finance the firm, and will include
higher expenses before interest and taxes
(EBIT). The higher the degree of financial
leverage, the more volatile EPS will be, all
other things remaining the same. The
formula is as follows:

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Financial Leverage
 Degree of Financial Leverage
 Finance a portion of the firm’s assets with
securities that have fixed financial costs
 Debt

 Preferred Stock

 Financial Leverage measures changes in

earnings per share as EBIT changes.

% Change in NI
DFLEBIT =
% Change in EBIT

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BaseLevel
Levelof
ofEBIT
EBIT 25
Degree of Financial Leverage
Degree of Financial Leverage measures the amount of risk
a company takes up when it borrows more debt (and
increases the debt portion
of its capital structure). The formula for Degree of
Financial Leverage is:

Degree of Financial Earnings Before Interest & Taxes (EBIT)

Leverage Earnings Before Taxes (EBT)

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Financial Leverage
The formula is as follows:

Example: EBIT = Rs500,000

Interest Charges = Rs200,000

500,000
DFLEBIT=500,000 = 500,000 – 200,000

= 1.67 times
Interpretation:
Interpretation: When
When EBIT
EBIT changes
changes1% 1% (from
(from
an
an existing
existing level
levelof
ofRs500,000)
Rs500,000)Net
Net Income
Income
will
willchange
change1.67%
1.67%ininthe
thesame
samedirection.
direction.

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 Financial Leverage
Example: EBIT = Rs500,000
Interest Charges = Rs200,000

500,000
DFLEBIT=500,000 = 500,000 – 200,000

= 1.67 times
Interpretation:
Interpretation: When
When EBIT
EBIT changes
changes1% 1% (from
(from
an
an existing
existing level
levelof
ofRs500,000)
Rs500,000)Net
Net Income
Income
will
willchange
change1.67%
1.67%ininthe
thesame
samedirection.
direction.

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To illustrate Degree of Financial Leverage,
lets do a hypothetical question

 . Imagine there are 3 firms, Firm A, Firm B

and Firm C. Each one has an interest
expense of $12000 in the year 2006. The
Earnings Before Taxes for each firm is given
below in the table. Can you calculate the
Degree of Financial Leverage using this
data?
 Interest Expense = $80,000 x 15% = $12000

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   Firm A Firm B Firm C

EBIT 25000 50000 75000

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   Firm A Firm B Firm C
EBIT 25000 50000 75000
EBT (EBIT - 25000 - 50000 - 75000 -
Interest 12000 12000 12000
Expense) = 13000 = 38000 = 63000
Degree of
Financial 25000 / 50000 / 75000 /
Leverage 13000 38000 63000
(EBIT / = 1.92 = 1.32 = 1.19
EBT)

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Future returns based on
probability

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 A practical illustration
Supposing elections are to be held in a short
time and an analyst pictures the following
three scenarios

1) Scenario 1 with a probability of 025%

A stable government with majority rule
A rate of return is forecasted to be around
36%
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2) Scenario 2 with a probability of
0.50%
 
A coalition government lasting its
full term.
A rate of return is forecasted to be
around 26%
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 3) Scenario 3 with a probability of
0.25%

Re-elections in the immediate

future.
A rate of return is forecasted to be
around 12%
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 This three scenarios will cover all
possible situations and hence the
total of all the probabilities will be 1
meaning there cannot be another
possible situation.

We put the information in the form of a

table
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Scenario Probability Expected
Return

1 0.25 36%

2 0.50 26%

3 0.25 12%

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 Now an investor will ask a very simple
question considering all the possible
situations and values involved what
would be my average expected
return?

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The expected average return is nothing
but the weighted average return of all
the returns and where the weights are
the respective probabilities.
 

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Scenario Probability Expected Average
Return

1 0.25 36% (.25*36) =9

2 0.50 26% (.50*26)=13

3 0.25 12% (.25*12)=3

9+13+3=25%

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 Given a probability distribution of returns, the expected return
can be calculated using the following equation:

 where
 E[R] = the expected return on the stock,
 N = the number of states,
 pi = the probability of state i, and
 Ri = the return on the stock in state i.

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Risk
 Given an asset's expected return, its
variance can be calculated using the
following equation:

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 where
 N = the number of states,
 pi = the probability of state i,
 Ri = the return on the stock in state i,
and
 E[R] = the expected return on the
stock.
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 The standard deviation is calculated as
the positive square root of the
variance.

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Indifference EBIT Example

 ABC Corp. currently has 200,000

shares outstanding on the stock market
with the current price being $20. The
Board of Directors of the Corp want to
incur a debt of $1 million by issuing junk
bonds that have a coupon interest rate
of 9% annually. At what point of EBIT
would the Corp. be indifferent to having
debt or NO debt?
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 Current Capital Structure = $20 x
200,000 shares = $4,000,000 Equity
 New Capital Structure = $3,000,000
Equity & $1,000,000 Debt
 - Current Stock Price Remains at $20.
- To attain $3,000,000 of Equity, the # of
shares = 150,000.
 Annual Interest Expense Coupon
Payments = 9% x 1,000,000 = $90,000
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   No Debt With Debt  

EBIT - 0 = EBIT - 90,000

Indifference EBIT  
200,000 150,000

150,000 EBIT = 200,000 (EBIT - 90,000)

150,000 EBIT = 200000EBIT - 18000000000
18000000000 = 200,000 EBIT - 150,000 EBIT
Indifference EBIT
18000000000 = 50,000 EBIT
EBIT = 18000000000 / 50,000
EBIT = $360,000

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 Interpretation of EBIT
 At a point where Earnings Before Interest
& Taxes is $360,000, ABC Corp. will not
care whether it has any outstanding debt
issues, NO debt or a combination of both
because at this point, the value of the
Capital Structure is NOT affected.
  
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 Why does the bond rating and
cost of debt depend upon the
amount borrowed?

As the firm borrows more money, the

firm increases its risk causing the
firm’s bond rating to decrease, and its
cost of debt to increase.

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Other factors to consider when
establishing the firm’s target
capital structure?
1. Industry average debt ratio
2. TIE ratios under different scenarios
3. Lender/rating agency attitudes
4. Reserve borrowing capacity
5. Effects of financing on control
6. Asset structure
7. Expected tax rate
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Financial Leverage of Ten Largest Indian
Companies, 2006

Company Capital Gearing Income Gearing

Debt ratio Debt–equity ratio Interest coverage Interest to EBIT ratio

1. Indian Oil 0.556 1.25:1 4.00 0.250

2. HPCL 0.350 0.54:1 5.15 0.194

3. BPCL 0.490 0.96:1 5.38 0.186

4. SAIL 0.858 6.00:1 - ve - ve

5. ONGC 0.106 0.12:1 53.49 0.019

6. TELCO 0.484 0.94:1 0.99 1.007

7. TISCO 0.577 1.37:1 1.62 0.616

8. BHEL 0.132 0.15:1 8.36 0.120

9. Reliance 0.430 0.75:1 3.46 0.289

10. L&T 0.522 1.09:1 2.31 0.433

11. HLL 0.027 0.03:1 264.92 0.004

12. Infosys 0.000 0.00:1 NA* NA*

13. Voltas 0.430 0.72:1 2.64 0.378

Note
Three commonly used ratios for
analyzing leverage are debt to
assets, long term debt to equity
and times interest earned. These
ratios should be of interest to
both creditors and members.

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 Times interest earned (TIE) is
calculated by dividing earnings
before interest and taxes by
interest payments. Creditors want
to know if the organisation’s
operations generate enough
margins to cover the interest
payments.
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Long-term Debt Ratios for
Selected Industries
Industry Long-Term Debt Ratio
Pharmaceuticals 20.00%
Computers 25.93
Steel 39.76
Aerospace 43.18
Airlines 56.33
Utilities 56.52
Source: Dow Jones News Retrieval. Data
collected through December 17, 1999.
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net earnings:

Gross sales minus taxes, interest, depreciation, and
other expenses.
Net earnings are one of the most important measures of
a company's
performance, since the pursuit of earnings is the
primary reason
companies exist. Sometimes net earnings includes one-
time and
extraordinary items, and sometimes it does not. also
called net
earnings or net income or bottom line.

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