Financial Leverage and

Capital Structure Policy

ACU 07311
 Define financial leverage
Financial leverage is the use of
borrowed money (debt) to finance
the purchase of assets with the
expectation that the income or
capital gain from the new asset
will exceed the cost of borrowing.
 Define financial leverage…
• In most cases, the provider of the debt will put a
limit on how much risk it is ready to take and
indicate a limit on the extent of the leverage it will
allow.
• In the case of asset-backed lending, the financial
provider uses the assets as collateral until the
borrower repays the loan.
• In the case of a cash flow loan, the general
creditworthiness of the company is used to back
the loan.
 Define financial leverage…
• The extent to which a firm relies
on debt
• The more debt financing a firm
uses in its capital structure, the
more financial leverage it
employs
 Capital Structure
• A company can use debt as well as equity
in the form of capital. So, the mix of debt
and equity that a company uses to
finance its assets and operations is what
we call capital structure.
• Or, we can say capital structure refers to
different combinations of debt and equity
that a company uses.
Capital Structure…
 The Effect of debt finance on the risk and
returns of equity holders…

• The effect of leverage depends on the

company’s EBIT. When EBIT is
relatively high, leverage is beneficial
• Under the expected scenarios,
leverage increase the returns to
shareholders, as measured by both
ROE and EPS
 The Effect of debt finance on the risk and returns of
equity holders

• Shareholders are exposed to more risk under

the proposed capital structure because the
EPS and ROE are much more sensitive to
changes in EBIT in this case
• Because of the impact that financial leverage
has on both the expected return to
stockholder and the riskiness of the stock,
capital structure is an important consideration
 Illustration of Effect of Financial Leverage

The calculation below clearly shows the

effect of having debt in the capital. The
table shows two options of financing,
one by equity only and another by
debt and equity.
 Example
Particulars Only Equity Debt + Equity

Equity Shares of TZs. 10 Each 5,000,000 2,500,000

Debt @ 12 % 0 2,500,000

EBIT 1,200,000 1,200,000

Interest 0 300,000

PBT 1,200,000 900,000

Tax – 50% 600,000 450,000

PAT 600,000 450,000

No. of Shares 500,000 250,000

EPS 1.2 1.8

ROE 12% 18%

 Effect of Financial Leverage…
• The return on equity (ROE) and the
EPS both are higher in the case of
debt and equity structure.
• It shows that the return on equity
has increased with the introduction
of leverage in the capital structure.
 Effect of Financial Leverage…
• The picture shown in the above
illustration does not bring all aspects
of leverage.
• Hence, we shall go further inside to
know the reason for having higher
EPS and ROE in the case of a levered
firm.
 Effect of Financial Leverage…
• Let us calculate one more
important ratio – ROI (Return on
Investment).
• ROI in both the options is 24%
• (EBIT / Total Investment =
1,200,000 / 5,000,000).
 Effect of Financial Leverage…
• Now, here we see that the ROI is more than
the interest rate charged by the lender, i.e.,
12%.
• This is the reason behind the higher EPS as
well as ROE in the case of a levered firm.
• So, leverage would not always be profitable.
The following matrix explains the behavior of
levering a firm.
 Behavior of levering a firm

Favorable ROI > Interest rate

Unfavorable ROI < Interest Rate

Neutral ROI = Interest Rate

 Values of Unlevered Versus Levered
• An unlevered company does not present a default risk to
investors because it does not have debt on which it can
default.
• An unlevered company presents a lower investment risk.
• A levered company utilizes debt financing for its
investments and operations.
• For investors, the investment risk increases in levered
companies because the possibility exists that the firm
may fail to meet its debt obligations and end up filing for
bankruptcy protection.
 Values of Unlevered Versus Levered
Value of Equity
• An unlevered firm carries no debt and is financed
completely through equity.
• The value of equity in an unlevered firm is equal to
the value of the firm.
• The equation to calculate the value of an unlevered
firm is:

• [(Pre-tax earnings)(1-corporate tax rate)] / the

required rate of return.
 Values of Unlevered Versus Levered
• The required rate of return is also referred to
as the cost of equity.
• Firms often use the capital asset pricing model
or the dividend capitalization model to
determine its required rate of return.
• The required rate of return is considered the
minimum return investors are willing to
accept.
 Values of Unlevered Versus Levered
• In a world of no taxes, the value of the firm is unaffected by
capital structure.
• This is M&M Proposition I:
VL = VU
Whre by;

VL = Value of Leverage Firm

VU = Value of Unleverage Firm
 Values of Unlevered Versus Levered…
• Proposition I holds because shareholders can achieve any pattern of
payouts they desire with homemade leverage.
• In a world of no taxes, M&M Proposition II states that leverage increases
the risk and return to stockholders

B
RS  R0   (R0  RB )
SL
RB is the interest rate (cost of debt).
Rs is the return on (levered) equity (cost of equity).

R0 is the return on unlevered equity (cost of capital).
B is the value of debt.
S is the value of levered equity.
 Values of Unlevered Versus Levered
• In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
• This is M&M Proposition I:
VL = VU + TC B
Where by;
VL = Value of Leverage Firm
VU = Value of Unleverage Firm
TC = Corporate Tax

B= the value of debt

 Values of Unlevered Versus Levered…
• Proposition I holds because shareholders can
achieve any pattern of payouts they desire with
homemade leverage.
• In a world of taxes, M&M Proposition II states
that leverage increases the risk and return to
stockholders
 What is a Tax Shield?
A Tax Shield is an allowable deduction
from taxable income that results in a
reduction of taxes owed. Tax shields differ
between countries and are based on what
deductions are eligible versus ineligible. The
value of these shields depends on the
effective tax rate for the corporation or
individual (being subject to a higher rate
increases the value of the deductions).
 What is a Tax Shield?
Common expenses that are deductible
include depreciation, amortization,
mortgage payments, and interest
expense. There are cases where
income can be lowered for a certain
year due to previously unclaimed tax
losses from prior years
 Interest tax shield
• Refers to the reduced income taxes
brought about by deductions to taxable
income from a company's interest
expense.
• For instance, there are cases where
mortgages may have an interest tax
shield for buyers since the mortgage
interest is deductible against income
 Interest tax shield…
• Tax Shield is calculated using the following
formula;
– Tax Shield = Deduction x Tax Rate

• Therefore the value of levered firm with tax

shield is calculated using the following
formula
– VL = VU + PV (Tax Shield) - PV (CFD)