CAPITAL STRUCTURE AND LEVERAGE
TOPIC 7
Capital Structure - amount of debt and/or equity used by a firm to fund its operations and finance its
assets. Debt and equity capital are employed to finance business operations, capital expenditures,
acquisitions and other investments. There are tradeoffs firms have to make when they decide whether to
use debt or equity to finance operations, and managers will balance the two to find the optimal capital
structure.
OPTIMAL CAPITAL STRUCTURE- is the best mix of debt and equity financing that maximizes its
stock price and minimizes its cost of capital.
RELEVANT CONCEPTS:
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Leverage represents the use of fixed cost items to magnify the firm's results.
*
Breakeven analysis allows the firm to determine the magnitude of operations necessary to
avoid loss.
*
Operating leverage indicates the extent fixed assets (plant & equipment) are utilized by
the firm.
*
Financial leverage shows how much debt the firm employs in its capital structure.
*
Combined leverage takes into account both the use of fixed assets and debt.
*
By increasing leverage, the firm increases its profit potential, but also its risk of failure.
I
Leverage in a Business: The use of fixed charge obligations with the intent of
magnifying the potential return to the firm.
II.
A.
Fixed operating costs: Those operating costs that remain relatively constant regardless of
the volume of operations such as rent, depreciation, property taxes, and executive salaries.
B.
Fixed financial costs: The interest costs arising from debt financing that must be paid
regardless of the level of sales or profits.
Operating Leverage
A.
Break-even analysis: A numerical and graphical technique used to determine at what point
the firm will break even.
1.
Break-even point: the unit sales where total revenue = total costs
2.
Contribution Margin per unit is sales price (per unit) minus variable costs per unit.
3.
Formula for break-even point in units:
B.
The risk factor in using financial leverage depends on the firm’s operations relative to its
breakeven point and its operating leverage. Management’s willingness to take risk is also
a function of its view of future economic conditions.
C.
Operating leverage: A reflection of the extent fixed assets and fixed costs are utilized in
the business firm. The employment of operating leverage causes operating profit to be
more sensitive to changes in sales.
The DOL may also be computed using the formula:
where:
Q
=
P
=
VC
=
FC
=
CM =
EBIT =
quantity at which DOL is computed
price per unit
variable cost per unit
fixed costs
Contribution Margin
Earnings Before Interest and Taxes
III.
Financial Leverage: A measure of the amount of debt used in the capital structure of
the firm.
A.
Two firms may have the same operating income but greatly different net incomes due to
the magnification effect of financial leverage. The higher the financial leverage, the
greater the profits or losses at high or low levels of operating profit, respectively.
B.
While operating leverage primarily pertains to the left-hand side of the balance sheet
(assets and associated costs), financial leverage deals with the right-hand side of the
balance sheet (liabilities and net worth).
C.
Financial leverage is beneficial only if the firm can employ the borrowed funds to earn a
higher rate of return than the interest rate on the borrowed amount. The extent of a firm's
use of financial leverage may be measured by computing its degree of financial leverage
(DFL). The DFL is the ratio of the percentage change in net income (or earnings per share)
in response to a percentage change in EBIT.
D.
The DFL may also be computed utilizing the following formula:
E.
The DFL is associated with a specific level of EBIT and changes as EBIT changes.
F.
The purpose of employing financial leverage is to increase return to the owners but its
use also increases their risk.
G.
The use of financial leverage is not unlimited.
1.
Interest rates that a firm must pay for debt-financing rise as it becomes more highly
leveraged.
2.
As the risk to the stockholders increases with leverage, their required rate of
return increases and stock prices may decline.
IV.
Combining Operating and Financial Leverage
A.
Combining operating and financial leverage provides maximum magnification of returnsit also magnifies the risk.
B.
The combined leverage effect can be illustrated through the income statement.
C.
The Degree of Combined Leverage may be computed as follows:
HAMADA EQUATION- a method of analyzing a firm’s cost of capital as it uses additional
financial leverage. The higher the Hamada equation beta coefficient, the higher the risk
associated with the firm.
The formula for unlevered beta is bu = bL/[1 + (1-T)(D/E) this is the beta coefficient when
there is no debt.
The formula for levered beta is
bL =bu[(1-T) (D/E)]