Dr.

Komal Taneja
(Ph.D (Management), MBA (Finance), M.com, UGC NET (Management), MP-SLET
(Commerce))

ASSOCIATE PROFESSOR
Sant Hirdaram Institute of Management
Bhopal
E-mail: profkomaltaneja@gmail.com
 LEVERAGE
 Leverage is the employment of an asset/source of
finance for which firm pays fixed cost/fixed return
TYPES OF
LEVERAGE
 OPERATING LEVERAGE : leverage associated
with investment (asset acquisition) activities
 FINANCING LEVERAGE : leverage associated
with financing activities
 OPERATING
 LEVERAGE
Operating leverage may be defined as the firm’s ability to
use fixed operating costs to magnify the effects of
changes in sales on its earning before interest and
taxes.
 It is determined by the relationship between the firm’s
sales revenues and its earning before interest and
taxes.
 It is caused due to fixed operating expenses in a firm.
 OPERATING
TheLEVERAGE
operating costs of a firm fall into three
categories:
1. Fixed costs : which don’t vary with sales volume
2. Variable costs : which vary directly with sales
3. Semi-variable or Semi-fixed costs : which are partly
fixed and partly variable
DEGREE OF OPERATING LEVERAGE
(DOL)
 DOL measures in quantitative terms the extent or degree of operating leverage
 The greater the DOL, the higher is
the operating leverage

%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
DOL = ∗
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠
100
EBIT = S-V-F
Where S = sales
V = variable cost per unit
F = total fixed cost
 DEGREE OF OPERATING LEVERAGE
(DOL)
 Since DOL depends on fixed operating costs, it
largely follows that the larger the fixed
operating costs, the higher is the degree of
operating leverage of the firm.
 FINANCIAL
 LEVERAGE
Financial leverage is defined as the ability of a firm to
use fixed financial charges to magnify the effect of
changes in EBIT on EPS
 It is caused due to fixed financial costs (interests) to
the firm
 It represents the relationship between the firm’s
earnings before interest and taxes (operating profits)
and the earnings available for ordinary shareholders
DEGREE OF FINANCIAL LEVERAGE (DFL)
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
 DFL >1
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
= 𝐸𝐵𝐼𝑇
(𝐸𝐵𝐼𝑇−)𝐼
, when debt is used
 DFL
𝐸𝐵𝐼𝑇
=DFL = , when debt
(𝐸𝐵𝐼𝑇−𝐼−𝐷𝑝) (1−𝑡)
and preference capital is used
𝐸 𝐵𝐼𝑇
 DFL = , when
[𝐸𝐵𝐼𝑇−𝐼−(𝐷𝑝+𝐷𝑡) (1−𝑡)]
dividends paid on preference
share capital are subject to dividend
tax
COMBINED LEVERAGE
Combined leverage is the product of operating
leverage and financial leverage

CL = OL * FL
DEGREE OF COMBINED LEVERAGE
DCL = DOL * DFL
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
DCL = 𝐸𝐵𝐼𝑇−𝐼
DCL measures the percentage
change in EPS due to percentage
change in sales
Sources of Long-term Finance
Introduction
As we are aware, finance is the life blood of business and
is of vital significance for modern business which requires
huge capital. Funds required for a business maybe
classified as long term and short term. Long term finance
is required for purchasing fixed assets like land and
building, machinery etc. The amount of long term capital
depends upon the scale of business and nature of
business.
 Long Term Finance – Its meaning and
purpose
• A business requires funds to purchase fixed assets like land and
building, plant and machinery, furniture etc. These assets may be
regarded as the foundation of business. The capital required for
these assets is called: fixed capital
• A part of the working capital is also of a permanent nature. Funds
required for this part of the working capital and for fixed capital is called
long term finance.
Purpose of long term finance:
1. Finance fixed assets:
• Business requires fixed assets like
machines, Building, furniture etc. Finance required to buy these
assets is for a long period, because such assets can be used for a
long period and are not for resale.
2. To finance the permanent part of working capital:
• Business is a continuing activity. It must have a certain amount of
working capital which would be needed again and again. This part
of working capital is of a fixed or permanent nature. This
requirement is also met from long term funds.
3. To finance growth and expansion of business:
• Expansion of business requires investment of a huge
amount of capital permanently or for a long period.
Factors determining long-term financial requirements
(a) Nature of Business:
The nature and character of a business determines the amount of fixed capital. A manufacturing
company requires land, building, machines etc. So it has to invest a large amount of capital for a long
period. But abrading concern dealing in, say, washing machines will require a smaller amount of long term
fund because it does not have to buy building or machines.
(b) Nature of goods produced:
• If a business is engaged in manufacturing small and simple articles it will require a smaller amount of
fixed capital as compared tone manufacturing heavy machines or heavy consumer items like
cars, refrigerators etc. which will require more fixed
capital.
(c) Technology used:
• In heavy industries like steel the fixed capital investment is larger than in the case of a business
producing plastic jars using simple technology or producing goods using labour intensive technique.
 Sources of long term finance
The main sources of long term finance are as follows:
1. Shares: These are issued to the general public. These may be of two types: (i)Equity & (ii)Preference.
The holders of shares are the owners of the business.
2. Debentures: These are also issued to the general public. The
holders of debentures are the creditors of the company.
3. Public Deposits :General public also like to deposit their savings with popular and well established
company which can pay interest periodically and pay-back the deposit when due.
4. Retained earnings:
The company may not distribute the whole of its profits among its shareholders. It may retain a
part of the profits and utilize it as capital
5. Term loans from banks:
Many industrial development banks, cooperative banks and commercial banks grant medium term
loans for a period of three to five years.
6. Loan from financial institutions:
There are many specialized financial institutions established by the Central and State governments
which give long term loans at reasonable rate of interest. Some of these institutions are: Industrial
Finance Corporation of India ( IFCI), Industrial Development Bank of India (IDBI),Industrial Credit and
Investment Corporation of India (ICICI), Unit Trust of India( UTI ), State Finance Corporations etc.
 Shares
Issue of shares is the main source of long term finance. Shares are issued by joint
stock companies to the public. A company divides its capital into units of a
definite face value, say of Rs. 10 each or Rs. 100 each.
Each unit is called a share. A person holding shares is called a shareholder.
Investors are of different habits and temperaments.
Some want to take lesser risk and are interested in a regular income. There are
others who may take greater risking anticipation of huge profits in future. In order
to tap the savings of different types of people, a company may issue different
types of shares.
These are: 1.Preference shares, and 2. Equity Shares.
 Preference Shares
• Preference Shares are the shares which carry preferential rights over
the equity shares. These rights are(a) receiving dividends at a fixed
rate,(b) getting back the capital in case the company is wound-up.
• Investment in these shares are safe, and a preference shareholder
also gets dividend regularly.
 Equity Shares

• Equity shares are shares which do not enjoy any preferential right in the
matter of payment of dividend or repayment of capital. The equity
shareholder gets dividend only after the payment of dividends to the
preference shares.
• There is no fixed rate of dividend for equity shareholders. The rate of dividend
depends upon the surplus profits. In case of winding up of a company, the
equity share capital is refunded only after refunding the preference share
capital.
• Equity shareholders have the right to take part in the management of the
company. However, equity shares also carry more risk.
 MERITS :To the shareholders
1. In case there are good profits, the company pays dividend to the equity shareholders at a
higher rate.
2. The value of equity shares goes up in the stock market with the increase in profits of the
concern.
3. Equity shares can be easily sold in the stock market
4. Equity shareholders have greater say in the management of a company as they are
conferred voting rights by the Articles of Association.
To the Management
5. A company can raise fixed capital by issuing equity shares without creating any charge on its
fixed assets.
6. The capital raised by issuing equity shares is not required to be paid back during the life time
of the company. It will be paid back only if the company is wound up.
7. There is no liability on the company regarding payment of dividend on equity shares. The
company may declare dividend only if there are enough profits.
8. If a company raises more capital by issuing equity shares, it leads to greater confidence
among the investors and creditors.
 Characteristics of shares

• The main characteristics of shares are following:

1. It is a unit of capital of the company.
2. Each share is of a definite face value.
3. A share certificate is issued to a shareholder indicating the number
of shares and the amount.
4. Each share has a distinct number.
5. The face value of a share indicates the interest of a person in the
company and the extent of his liability.
6. Shares are transferable units.
 Debentures
Whenever a company wants to borrow a large amount of fund for a
long but fixed period, it can borrow from the general public by issuing
loan certificates called Debentures. The total amount to be borrowed is
divided into units of fixed amount say of Rs.100 each.

These units are called Debentures. These are offered to the public to
subscribe in the same manner as isdone in the case of shares. A
debenture is issued under the common seal of the company. It is a
written acknowledgement of money borrowed. It specifies the terms
and conditions, such as rate of interest, time repayment, security
offered, etc.
Characteristics of Debenture

• Following are the characteristics of Debentures

1)Debenture holders are the creditors of the company. They are
entitled to periodic payment of interest at a fixed rate.
2) Debentures are repayable after a fixed period of time, say five years
or seven years as per agreed terms.
3) Debenture holders do not carry voting rights.
4) Ordinarily, debentures are secured. In case the company fails to
pay interest on debentures or repay the principal amount, the
debenture holders can recover it from the sale of the assets of
the company.
 Types of Debentures
• Debentures may be classified as:
a) Redeemable Debentures and Irredeemable Debentures
b) Convertible Debentures and Non-convertible Debentures.
• Redeemable Debentures :
These are debentures repayable on a pre-determined date or at any time prior to their
maturity, provided the company so desires and gives a notice to that effect.
• Irredeemable Debentures :
These are also called perpetual debentures. Accompany is not bound to repay the
amount during its life time. If the issuing company fails to pay the interest, it has to
redeem such debentures.
• Convertible Debentures :
The holders of these debentures are given the option to convert their debentures into
equity shares at a time and in a ratio as decided by the company.
• Non-convertible Debentures:
These debentures cannot be converted into shares.
 Retained Earnings
• Like an individual, companies also set aside a part of their profits to meet
future requirements of capital. Companies keep these savings in various
accounts such as General Reserve, Debenture Redemption Reserve and
Dividend Equalization Reserve etc.
• These reserves can be used to meet long term financial requirements. The
portion of the profits which is not distributed among the shareholders but is
retained and is used in business is called retained earnings or ploughing back
of profits.
• As per Indian Companies Act., companies are required to transfer a part of
their profits in reserves. The amount so kept in reserve may be used to buy
fixed assets. This is called internal financing.
 Merits :
Following are the benefits of retained earnings:
1. Cheap Source of Capital :
No expenses are incurred when capital is available from this source. There is no
obligation on the part of the company either to pay interest or pay back the
money. It can safely be used for expansion and modernization of business.
2. Financial stability :
A company which has enough reserves can face ups and downs in business.
Such companies can continue with their business even in depression, thus
building up its goodwill.
3. Benefits to the shareholders:
Shareholders may get dividend out of reserves even if the company does not
earn enough profit. Due to reserves, there is capital appreciation, i.e. the
value of shares go up in the share market .
 Limitation
1. Huge Profit :
This method of financing is possible only when there are
huge profits and that too for many years.
2. Dissatisfaction among shareholders :
When funds accumulate in reserves, bonus shares are issued to the shareholders to
capitalize such funds. Hence the company has to pay more dividends. By retained earnings
the real capital does not increase while the liability increases. In case bonus shares are
not issued, it may create a situation of under–capitalisation because the rate of dividend
will be much higher as compared to other companies.
3. Fear of monopoly :
Through ploughing back of profits, companies increase their financial strength. Companies
may throw out their competitors from the market and monopolize their position.
4. Mis-management of funds :
Capital accumulated through retained earnings encourages management to spend
carelessly.
CAPITAL STRUCTURE
Capital structure can be defined as the mix of owned capital
(equity, reserves & surplus) and borrowed capital (debentures,
loans from banks, financial institutions)
Maximization of shareholders’ wealth is prime objective of a
company. The same may be achieved by designing an optimal
capital structure for the company.
FEATURES OF AN APPROPRIATE CAPITAL
STRUCTURE
 Optimal capital structure is that capital structure at which level of
debt – equity proportion is such where the market value per share is
maximum and the cost of capital is minimum.
Consideration to be kept in mind while maximising the value of the
firm in achieving the goal of the optimal capital structure:
 If ROI > the fixed cost of funds, the company should prefer to
raise the funds having a fixed cost, such as, debentures, Loans . It
will increase EPS and MV of the firm.
 If debt is used as a source of finance, the firm saves a considerable
amount in payment of tax as interest is allowed as a deductible
expense in computation of tax.
 It should also avoid undue financial risk attached with the use of
increased debt financing.
 The Capital structure should be flexible.
DETERMINANTS OF CAPITAL STRUCTURE
 Seasonal Variations
 Tax benefit of Debt
 Flexibility
 Industry Leverage Ratios
 Agency Costs
 Industry Life Cycle
 Degree of Competition
 Company Characteristics
 Requirements of
Investors
 Timing of Public Issue
 Legal Requirements

Factors affecting capital structure
EXTERNAL
INTERNAL  Size of the company
 Financial leverage  Nature of the industry
 Risk  Investors
 Growth and stability  Cost of inflation
 Retaining control  Legal requirements
 Cost of capital  Period of finance
 Cash flows  Level of interest rate
 Flexibility  Level of business activity
 Purpose of finance  Availability of funds
 Asset structure  Taxation policy
 Level of stock prices
 Conditions of the capital market
Planning the Capital Structure Important
Considerations –
 Return: ability to generate maximum returns to the shareholders,
i.e. maximize EPS and market price per share.
 Cost: minimizes the cost of capital (WACC). Debt is cheaper than
equity due to tax shield on interest & no benefit on dividends.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of management control, hence debt
preferred to new equity shares.
 Flexible: altering capital structure without much costs & delays, to
raise funds whenever required.
 Capacity: ability to generate profits to pay interest and principal.
CAPITAL STRUCTURE THEORIES
ASSUMPTIONS –
 Firms use only two sources of funds – equity & debt.
 No change in investment decisions of the firm, i.e. no change in total assets.
 100 % dividend payout ratio, i.e. no retained earnings.
 Business risk of firm is not affected by the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of the firm.
A) Net Income Approach (NI)
 Net Income approach proposes that there is a definite relationship
between capital structure and value of the firm.
 The capital structure of a firm influences its cost of capital
(WACC), and thus directly affects the value of the firm.
 NI approach assumptions –
o NI approach assumes that a continuous increase in
debt does
not affect the risk perception of investors.
o Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd
< Ke ]
o Corporate income taxes do not exist.
Net Income Approach (NI)
 As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Earnings (NOI or EBIT)
WACC
 Earnings (EBIT) being constant and WACC is reduced, the value
of a firm will always increase.
 Thus, as per NI approach, a firm will have maximum value at a
point where WACC is minimum, i.e. when the firm is almost debt-
financed. Thus there can be an Optimal Capital Structure.
Net Income Approach (NI)

Cos t
As the proportion of
debt (Kd) in capital
structure increases,
k e, k o ke
the WACC (K o)
kd
ko
kd reduces.

Debt
Net Income Approach (NI)
Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000. Ke = 10% Kd = 6%
Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000

Particulars case 1 case 2 case 3

EBIT 200,000 200,000 200,000
(-) Interest 30,000 42,000 12,000
EBT 170,000 158,000 188,000

Ke 10% 10% 10%

Value of Equity 1,700,000 1,580,000 1,880,000
(EBT / Ke)

Value of Debt 500,000 700,000 200,000

Total Value of Firm 2,200,000 2,280,000 2,080,000

WACC 9.09% 8.77% 9.62%

(EBIT / Value) * 100
Net Operating Income (NOI)
 Net Operating Income (NOI) approach is the exact opposite of
the Net Income (NI) approach.
 As per NOI approach, value of a firm is not dependent upon its
capital structure. Thus there is no Optimal Capital Structure.
 Assumptions –
o WACC is always constant, and it depends on the business risk
which remains constant.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only. Thus the split between debt and equity is
not important.
o The cost of debt (Kd) is constant.

o Corporate income taxes do not exist.

 Net Operating Income (NOI)
 NOI propositions (i.e. school of thought) –
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (Ke)
A higher cost of equity (Ke) nullifies the advantages gained due
to cheaper cost of debt (Kd )
In other words, the finance mix is irrelevant and does not affect
the value of the firm.
NEUTRALIZATION
 The increase in the proportion of debt in the Capital
Structure would lead to increase in the financial risk of
equity share holders. The advantage associated with
the use of the relatively less expensive debt in terms of
explicit cost is exactly neutralized by the implicit cost
of debt represented by the increase in the cost of equity
capital.
Net Operating Income (NOI)
 Cost of capital (Ko)
Cost is constant.
ke
 As the proportion
of debt increases,
ko
(Ke) increases.
kd
 No effect on total
cost of capital (WACC)
Debt
Net Operating Income (NOI)
Calculate the value of firm and cost of equity for the following capital structure -
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3
options)
Particulars Option I Option II Option III
EBIT 200,000 200,000 200,000
WACC (Ko) 10% 10% 10%

Value of the firm 2,000,000 2,000,000 2,000,000

Value of Debt @ 6 % 300,000 400,000 500,000
Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000

Interest @ 6 % 18,000 24,000 30,000

EBT (EBIT - interest) 182,000 176,000 170,000

Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%

Traditional Approach
 The NI approach and NOI approach hold extreme views on the
relationship between capital structure, cost of capital and the value
of a firm.
 Traditional approach (‘intermediate approach’) is a compromise
between these two extreme approaches.
 Traditional approach confirms the existence of an optimal capital
structure; where WACC is minimum and value is the firm is
maximum.
 As per this approach, a best possible mix of debt and equity will
maximize the value of the firm.
Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings (since
Kd < Ke). As a result, the WACC reduces gradually. This
phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases and
it tends to stabilize. Further increase in borrowings will not affect
WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’ risk
(financial risk) and hence Ke increases. Kd also rises due to higher
debt, WACC increases & value of firm decreases.
Traditional Approach
 Cost of capital (Ko) is
reduces initially.
Cost
 At a point, it settles
ke
 But after this point, (Ko)
increases, due to increase in the
ko cost of equity. (Ke)

kd

Debt
Traditional Approach
EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to
the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.
For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC

Particulars Presently case I case II

Debt component - 300,000 500,000
Rate of interest 0% 10% 12%
EBIT 150,000 150,000 150,000
(-) Interest - 30,000 60,000
EBT 150,000 120,000 90,000
Cost of equity (Ke) 16% 17% 20%
Value of Equity (EBT / Ke) 937,500 705,882 450,000
Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000
WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%
 Optimal Capital Structure:

Traditional Approach

ke
.25
ko
.20
Capital Costs (%)

.15
ki
.10
Optimal Capital Structure
.05

0
Financial Leverage (D / S)
Optimum Capital Structure

 The optimal (best) situation is associated with the

minimum overall cost of capital:
 Optimum capital structure means the lowest
WACC
 Usually occurs with 30-50% debt in a firm’s
capital structure
 WACC is also referred to as the required rate of return
or the discount rate
 Optimal Capital Structure

Cost (After-tax) Weights Weighted

Cost
Financial Plan A:
Debt………………………… 6.5% 20% 1.3%
Equity………………………. 12.0 80 9.6
10.9%
Financial Plan B:
Debt………………………… 7.0% 40% 2.8%
Equity………………………. 12.5 60 7.5
10.3%
Financial Plan C:
Debt………………………… 9.0% 60% 5.4%
Equity………………………. 15.0 40 6.0
11.4
%
Cost of capital curve
MODIGLIANI – MILLER MODEL
(MM)
 MM approach supports the NOI approach, i.e. the capital structure
(debt-equity mix) has no effect on value of a firm.
 Further, the MM model adds a behavioural justification in favour of the
NOI approach (personal leverage).
 Assumptions –
 Capital markets are perfect and investors are free to buy, sell, & switch
between securities. Securities are infinitely divisible.
 Investors can borrow without restrictions at par with the firms.
 Investors are rational & informed of risk-return of all
securities.
 All firms belong to a homogeneous risk class.
 No corporate income tax, and no transaction costs.
 100 % dividend payout ratio, i.e. no profits retention
Modigliani – Miller Model
(MM)
MM Model proposition –
o Value of a firm is independent of the capital
structure.
o Value of firm is equal to the capitalized value of
operating income (i.e. EBIT) by the appropriate rate (i.e.
WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of
Debt
= Expected EBIT or Expected NOI
Expected WACC or Overall Capitalization Rate
Modigliani – Miller Model
(MM)
MM Model proposition –
o As per MM, identical firms (except capital structure) will
have the same level of earnings.
o As per MM approach, if market values of identical
firms are different, ‘arbitrage process’ will take place.
o In this process, investors will switch their securities
between identical firms (from levered firms to un-levered
firms) and receive the same returns from both firms.