Chapter - 7

LEVERAGE & CAPITAL STRUCTURE

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CAPITAL BUDGETING DECISIONS

 CONCERNED ABOUT QUANTUM OF FINANCE TO BE

RAISED AND INVESTED

CAPITAL STRUCTURE DECISIONS

 PROPORTION IN WHICH FINANCE TO BE RAISED

FROM DIFFERENT SOURCES

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CAPITAL STRUCTURE – DEFINITION:

 ACCORDING TO GERSTENBERG, CAPITAL STRUCTURE

REFERS TO THE MAKE-UP OF A FIRM’S CAPITAL

 CAPITAL STRUCTURE REFERS TO THE MIX OR PROPORTION

OF LONG-TERM SOURCES OF FUNDS IN TOTAL

CAPITALISATION OF THE FIRM

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FUNDS REQUIRED BY A FIRM CAN BE RAISED THROUGH TWO
TYPES OF SECURITIES:
1. OWNERSHIP SECURITIES
 EQUITY SHARES
 PREFERENCE SHARES
 RETAINED EARNINGS

2. CREDITORSHIP SECURITIES
 DEBENTURES
 LONG-TERM LOANS
 BONDS 11/3/22 4
PATTERN OF CAPITAL STRUCTURE:

 IN CASE OF NEW COMPANY:

o EQUITY SHARES ONLY
o EQUITY SHARES AND PREFERENCE SHARES
o EQUITY SHARES AND DEBENTURES
o EQUITY, PREFERENCE SHARES AND DEBENTURES

 IN CASE OF AN EXISTING COMPANY, RETAINED EARNINGS

ARE ALSO INCLUDED

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LEVERAGE

 The use of the fixed-charges sources of funds, such as debt

and preference capital along with the owners’ equity in the

capital structure, is described as leverage or gearing or

trading on equity

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Degree of Operating Leverage
 Operating leverage affects a firm’s operating profit (EBIT)
 The degree of operating leverage (DOL)
the percentage change in the earnings before interest and
taxes relative to a given percentage change in sales

% Change in EBIT
DOL 
% Change in Sales
 EBIT/EBIT
DOL 
 Sales/Sales
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Degree of Financial Leverage
It is defined as the percentage change in EPS due to
a given percentage change in EBIT

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Combining Financial and Operating Leverages

Operating leverage affects a firm’s operating profit

(EBIT), while financial leverage affects profit after
tax or the earnings per share.

The degrees of operating and financial leverage is

combined to see the effect of total leverage on EPS
associated with a given change in sales.
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Combining Financial and Operating Leverages

The degree of combined leverage (DCL) is given by

the following equation:

% Change in EBIT % Change in EPS % Change in EPS

  
% Change in Sales % Change in EBIT % Change in Sales

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 CAPITAL STRUCTURE THEORIES
 THE OBJECTIVE OF A FIRM
 MAXIMIZATION OF THE FIRM’S VALUE

 The financial leverage employed by a company is intended to earn

more return on the fixed-charge funds than their costs.
 The surplus (or deficit) will increase (or decrease) the return on the
owners’ equity.
 THE CAPITAL STRUCTURE OR FINANCIAL LEVERAGE DECISION SHOULD
BE EXAMINED FROM THE POINT OF ITS IMPACT ON THE VALUE OF THE
FIRM

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 THE MAJOR THEORIES EXPLAINING THE RELATIONSHIP

BETWEEN CAPITAL STRUCTURE, COST OF CAPITAL AND

VALUE OF THE FIRM ARE:

1. NET INCOME (NI) THEORY

2. NET OPERATING INCOME (NOI) THEORY

3. MODIGILANI – MILLER (MM) APPROACH

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1. NET INCOME (NI) APPROACH:

 THIS APPROACH HAS BEEN SUGGESTED BY DURAND

 THE THEORY PROPOUNDS THAT A COMPANY CAN
INCREASE ITS VALUE AND REDUCE THE OVERALL COST
OF CAPITAL BY INCREASING THE PROPORTION OF DEBT
IN ITS CAPITAL STRUCTURE

ASSUMPTIONS OF NI THEORY:
 COST OF DEBT IS LESS THAN COST OF EQUITY
 THERE ARE NO TAXES
 RISK PERCEPTION OF INVESTORS DO NOT CHANGE BY USE OF DEBT

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ACCORDING TO NI APPROACH

VALUE OF FIRM = MARKET VALUE OF EQUITY + MARKET VALUE OF DEBT

V = S + D
EARNINGS AVAILABLE TO EQUITY SHAREHOLDERS (EBIT – I)
S = ------------------------------------------------------------------------------------------------------------
EQUITY CAPITALISATION RATE (OR) COST OF EQUITY (Ke)

EBIT – I EBIT - I
Ke = ------------- Ke = -------------
S V-D

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OVERALL (OR) WEIGHTED AVERAGE COST OF CAPITAL IS CALCULATED AS:

EBIT EBIT
KO = --------- V= --------
V KO
EBIT = EARNINGS BEFORE INTEREST AND TAX

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2. NET OPERATING INCOME (NOI) APPROACH:

 THIS APPROACH IS ALSO SUGGESTED BY DURAND

 ACCORDING TO THIS APPROACH, CHANGE IN CAPITAL STRUCTURE OF
A COMPANY DOES NOT AFFECT THE MARET VALUE OF FIRM AND
OVERALL COST OF CAPITAL REMAINS CONSTANT IRRESPECTIVE OF
METHOD OF FINANCING

 ASSUMPTIONS OF NOI APPROACH:

1. MARKET CAPITALISES THE VALUE OF THE FIRM AS A WHOLE AND
HENCE SPLIT BETWEEN DEBT AND EQUITY IS NOT RELEVANT
2. OVERALL COST OF CAPITAL REMAINS CONSTANT FOR ALL DEGREES
OF DEBT – EQUITY MIX OR LEVERAGE
3. THERE ARE NO CORPORATE TAXES
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PROPOSITION OF NOI APPROACH:

 THE REASONS PROPOUNDED FOR THE ASSUMPTIONS

ARE:

 INCREASED USE OF DEBT INCREASES FINANCIAL

RISK OF EQUITY SHAREHOLDERS AND HENCE COST

OF EQUITY INCREASES

 THE ADVANTAGE OF USING CHEAPER DEBT IS

OFFSET BY INCREASED COST OF EQUITY

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VALUE OF FIRM IS DETERMINED AS:

EBIT
V = --------
KO
EBIT = EARNINGS BEFORE INTEREST AND TAX

MARKET VALUE OF EQUITY IS DETERMINED AS:

S=V-D
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EQUITY CAPITALISATION RATE (OR) COST OF EQUITY (Ke) IS:

EBIT – I EBIT - I
Ke = ------------- Ke = -------------
S V-D
OVERALL COST OF CAPITAL CAN BE CALCULATED AS:

KO = Kd (D/V) + Ke (S/V)

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3. MODIGILANI – MILLER (MM) APPROACH:

 FRANCO MODIGILANI AND MERTON MILLER ARE

LAUREATES IN ECONOMICS

 MM HYPOTHESIS IS IDENTICAL WITH NOI APPROACH IF

TAXES ARE IGNORED

 IT IS IDENTICAL WITH NI APPROACH IF TAXES ARE

ASSUMED TO EXIST

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IN THE ABSENCE OF TAX (PROPOSITION – I):
 THE THEORY PROVES THAT THE COST OF CAPITAL IS NOT
AFFECTED BY CHANGES IN CAPITAL STRUCTURE
 THE REASON
 THOUGH DEBT IS CHEAPER THAN EQUITY, WITH
INCREASED USE OF DEBT AS A SOURCE OF FINANCE,
THE COST OF EQUITY INCREASES, WHICH OFFSETS THE
ADVANTAGE OF LOW COST OF DEBT
 HENCE, THE OVERALL COST OF CAPITAL REMAINS
CONSTANT
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 THE THEORY FURTHER PROPOUNDS THAT BEYOND A CERTAIN LIMIT OF
DEBT, COST OF DEBT ALSO INCREASES DUE TO INCREASED FINANCIAL
RISK, BUT COST OF EQUITY FALLS THEREBY AGAIN BALANCING THE
TWO COSTS
 IN THE OPTION OF MODIGILANI AND MILLER, TWO IDENTICAL FIRMS IN
ALL RESPECTS EXCEPT THEIR CAPITAL STRUCTURE CANNOT HAVE
DIFFERENT MARKET VALUES OR COST OF CAPITAL BECAUSE OF
ARBITRAGE PROCESS
 THE TERM ‘ARBITRAGE’ REFERS TO AN ACT OF BUYING AN ASSET OR
SECURITY IN ONE MARKET HAVING LOWER PRICE AND SELLING IT IN
ANOTHER MARKET AT A HIGHER PRICE

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 MM’S PROPOSITION-I IS THAT, FOR FIRMS IN THE SAME RISK

CLASS, THE TOTAL MARKET VALUE IS INDEPENDENT OF THE

DEBT-EQUITY MIX AND IS GIVEN BY CAPITALIZING THE

EXPECTED NET OPERATING INCOME BY THE CAPITALIZATION

RATE (i.e., THE OPPORTUNITY COST OF CAPITAL)

APPROPRIATE TO THAT RISK CLASS

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 MM’S PROPOSITION-I: KEY ASSUMPTIONS

 PERFECT CAPITAL MARKETS

 HOMOGENEOUS RISK CLASSES

 NO TAXES

 FULL PAYOUT

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ARBITRAGE PROCESS

 SUPPOSE TWO IDENTICAL FIRMS, EXCEPT FOR THEIR

CAPITAL STRUCTURES, HAVE DIFFERENT MARKET VALUES.

IN THIS SITUATION, ARBITRAGE (OR SWITCHING) WILL TAKE

PLACE TO ENABLE INVESTORS TO ENGAGE IN THE

PERSONAL OR HOMEMADE LEVERAGE AS AGAINST THE

CORPORATE LEVERAGE, TO RESTORE EQUILIBRIUM IN THE

MARKET.
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• ON THE BASIS OF THE ARBITRAGE PROCESS, MM

CONCLUDE THAT THE MARKET VALUE OF A FIRM IS NOT

AFFECTED BY LEVERAGE.

• THUS, THE FINANCING (OR CAPITAL STRUCTURE)

DECISION IS IRRELEVANT. IT DOES NOT HELP IN

CREATING ANY WEALTH FOR SHAREHOLDERS.

• HENCE ONE CAPITAL STRUCTURE IS AS MUCH DESIRABLE

(OR UNDESIRABLE) AS THE OTHER.11/3/22 27

RELEVANCE OF CAPITAL STRUCTURE: THE MM
HYPOTHESIS UNDER CORPORATE TAXES
(PROPOSTION – II)

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 MM SHOW THAT THE VALUE OF THE FIRM WILL INCREASE

WITH DEBT DUE TO THE DEDUCTIBILITY OF INTEREST

CHARGES FOR TAX COMPUTATION, AND THE VALUE OF THE

LEVERED FIRM WILL BE HIGHER THAN OF THE UNLEVERED

FIRM

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 EXAMPLE: DEBT ADVANTAGE: INTEREST TAX SHIELDS

 SUPPOSE TWO FIRMS L AND U ARE IDENTICAL IN ALL RESPECTS

EXCEPT THAT FIRM L IS LEVERED AND FIRM U IS UNLEVERED.

 FIRM U IS AN ALL-EQUITY FINANCED FIRM WHILE FIRM L EMPLOYS

EQUITY AND RS 5,000 DEBT AT 10 PER CENT RATE OF INTEREST.

 BOTH FIRMS HAVE AN EXPECTED EARNING BEFORE INTEREST AND

TAXES (OR NET OPERATING INCOME) OF RS 2,500, PAY CORPORATE

TAX AT 50 PER CENT AND DISTRIBUTE 100 PER CENT EARNINGS AS

DIVIDENDS TO SHAREHOLDERS.

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11/3/22 31
 YOU MAY NOTICE THAT THE TOTAL INCOME AFTER CORPORATE TAX IS
RS 1,250 FOR THE UNLEVERED FIRM U AND RS 1,500 FOR THE LEVERED
FIRM L.
 THUS, THE LEVERED FIRM L’S INVESTORS ARE AHEAD OF THE
UNLEVERED FIRM U’S INVESTORS BY RS 250.
 YOU MAY ALSO NOTE THAT THE TAX LIABILITY OF THE LEVERED FIRM L
IS RS 250 LESS THAN THE TAX LIABILITY OF THE UNLEVERED FIRM U.
 FOR FIRM L THE TAX SAVINGS HAS OCCURRED ON ACCOUNT OF
PAYMENT OF INTEREST TO DEBT HOLDERS.
 HENCE, THIS AMOUNT IS THE INTEREST TAX SHIELD OR TAX ADVANTAGE
OF DEBT OF FIRM L: 0.5 × (0.10 × 5,000) = 0.5 × 500 = RS 250.

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Value of Interest Tax Shield
 INTEREST TAX SHIELD IS A CASH INFLOW TO THE FIRM AND
THEREFORE, IT IS VALUABLE.
 THE CASH FLOWS ARISING ON ACCOUNT OF INTEREST TAX
SHIELD ARE LESS RISKY THAN THE FIRM’S OPERATING
INCOME THAT IS SUBJECT TO BUSINESS RISK.
 INTEREST TAX SHIELD DEPENDS ON THE CORPORATE TAX
RATE AND THE FIRM’S ABILITY TO EARN ENOUGH PROFIT
TO COVER THE INTEREST PAYMENTS.

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UNDER THE ASSUMPTION OF PERMANENT DEBT, THE
PRESENT VALUE OF THE INTEREST TAX SHIELD CAN BE
DETERMINED AS FOLLOWS:

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VALUE OF THE UNLEVERED FIRM

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VALUE OF THE LEVERED FIRM

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 IMPLICATIONS OF THE MM HYPOTHESIS WITH CORPORATE TAXES

 THE MM’S “TAX-CORRECTED” VIEW SUGGESTS THAT,

BECAUSE OF THE TAX DEDUCTIBILITY OF INTEREST
CHARGES, A FIRM CAN INCREASE ITS VALUE WITH
LEVERAGE. THUS, THE OPTIMUM CAPITAL STRUCTURE IS
REACHED WHEN THE FIRM EMPLOYS ALMOST 100 PER
CENT DEBT.
 IN PRACTICE, FIRMS DO NOT EMPLOY LARGE AMOUNTS
OF DEBT, NOR ARE LENDERS READY TO LEND BEYOND
CERTAIN LIMITS, WHICH THEY DECIDE.
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CAPITAL PLANNING DECISIONS
EBIT – EPS ANALYSIS:

 THE USE OF FINANCIAL LEVERAGE HAS TWO EFFECTS ON THE EARNINGS THAT
GO TO THE FIRM’S COMMON STOCKHOLDERS:

(1) AN INCREASED RISK IN EARNINGS PER SHARE (EPS) DUE TO THE USE OF FIXED
FINANCIAL OBLIGATIONS, AND

(2) A CHANGE IN THE LEVEL OF EPS AT A GIVEN EBIT ASSOCIATED WITH A SPECIFIC
CAPITAL STRUCTURE

 THE FIRST EFFECT IS MEASURED BY THE DEGREE OF FINANCIAL LEVERAGE

 THE SECOND EFFECT IS ANALYZED BY MEANS OF EBIT–EPS ANALYSIS

 EBIT – EPS ANALYSIS IS A PRACTICAL TOOL THAT ENABLES
TO EVALUATE ALTERNATIVE FINANCING PLANS BY
INVESTIGATING THEIR EFFECT ON EPS OVER A RANGE OF
EBIT LEVELS

 ITS PRIMARY OBJECTIVE IS TO DETERMINE THE EBIT BREAK-

EVEN, OR INDIFFERENCE POINTS AMONG THE VARIOUS
ALTERNATIVE FINANCING PLANS
THE INDIFFERENCE POINTS BETWEEN ANY TWO METHODS OF FINANCING
CAN BE DETERMINED BY SOLVING FOR EBIT IN THE FOLLOWING EQUALITY:

(EBIT – I)(1 – T) – PD (EBIT – I)(1 – T) – PD

------------------------------------- = -------------------------------------
S1 S2
WHERE,
T = TAX RATE
PD = PREFERRED STOCK DIVIDENDS
S1 AND S2 = NUMBER OF SHARES OF COMMON STOCK OUTSTANDING
AFTER FINANCING FOR PLAN 1 AND PLAN 2, RESPECTIVELY
ANY QUESTIONS?

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END - OF

CHAPTER
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