CHAPTER 9
Capital Structure and Leverage



Optimal capital structure
Business vs. financial risk
Leverage
The Target Capital Structure
 Capital Structure
The combination of debt and equity used
to finance a firm
 Target Capital Structure
The mix of debt, preferred stock, and
common equity with which the firm plans
to finance its investments
The Target Capital Structure
Four factors that influence capital structure
decisions:
1. The firm’s business risk
2. The firm’s tax position
3. Financial flexibility
4. Managerial attitude
risk

In a company, it has two types of risk:
Business risk
Financial risk

In this chapter, we will learn:
What is business risk & financial risk?
How to measure business risk?
How to measure financial risk?
Business Risk
Business risk: the riskiness inherent in
the firm’s operations if it uses no debt.
 经营风险：是公司经营中的内在风险，即在不
采用债务的情况下经营所面临的风险。

Business Risk

Two ways to analyze the business risk:
Breakeven analysis
Operating leverage
Breakeven analysis
Breakeven analysis: A technique for
studying the relationship among fixed
costs, variable costs, sales volume, and
profits.
 盈亏平衡分析（保本分析）：一种研究固定成
本、变动成本、销售量和利润之间关系的技术
方法。

Breakeven analysis
Breakeven occurs when EBIT = 0
Total revenue – Total cost = 0
PQ - VQ - FC = 0
Q(P - V) = FC
QBE (保本销售量)= FC / (P - V)
P = Price per unit (单价)
V = Variable costs per unit (单位变动成本)
FC = Fixed costs (固定成本)
Q = Quantity sold (销售量)
Breakeven analysis
Breakeven occurs when EBIT = 0
Total revenue – Total cost = 0
Total revenue = Total cost
Sales revenue = Fixed cost + Variable cost
Sales revenue = FC + V×Q
SBE (保本销售收入)= FC + V×QBE
Example
e.g.: A firm that produces a child’s bicycle:
Sells for $50 a unit
Annual fixed operating costs---$100,000
Variable operating costs---$25 a unit

QBE=$100,000/($50-$25)=4,000 units

SBE=$100,000+$25×4,000=$200,000
Breakeven Chart
REVENUES AND COSTS
Total Revenues
Profits
250000
Breakeven Point
保本点
Total Costs
200000
100000
Losses
FC
0
1,000 2,000 3,000 4,000 5,000 6,000 7,000
QUANTITY PRODUCED AND SOLD
Case study
Price
Variable costs
Fixed costs


Plan A
$2.00
$1.50
$20,000
Plan B
$2.00
$1.00
$60,000
What is the break point for plan A? (QBE, SBE)
What is the break point for plan B? (QBE, SBE)

For plan A:
Case study
 QBE=40,000 units
 SBE=$80,000

For plan B:
 QBE=60,000 units
 SBE=$120,000

Which one’s breakeven point is lower?
(plan A or plan B)
 Plan A

Which plan is easier to make profits?
 Plan A
Operating leverage
Operating leverage: the extent to which
fixed costs are used in a firm’s operations.
 经营杠杆：是在公司的经营过程中固定成本使
用的比重。

Operating leverage
Operating leverage is the ratio of
percentage change in EBIT divided by
percentage change in quantity sold.
 经营杠杆是息税前利润变动百分比与销售量变
动百分比之间的比率。

 EBIT
DOL 
EBIT
Q
Q

DOL (degree of operating leverage, 经营杠杆
系数)
Computing the DOL
DOLQ units
Q (P - V)
=
Q (P - V) - FC
Q
=
Q - QBE
Q
QBE
This equation is mainly for a single-product firm.
这个公式主要适用于单一产品公司。
Computing the DOL
DOLS dollars of sales
S - VC
=
S - VC - FC
=
EBIT + FC
EBIT
EBIT
FC
This equation is mainly for a multi-product firm.
这个公式主要适用于多产品公司。
Case study


Company Fox is a single-product firm. It
has two plans.
Plan A
Plan B
Price
$2.00
$2.00
Variable costs
$1.50
$1.00
Fixed costs
$20,000
$60,000
Units sold
100,000
100,000
What is the DOL for plan A and plan B?
Case study
DOL
DOL


A
B

100,000
100,000

 1.67
- 40,000
100,000
 2.5
100,000 - 60,000
Plan B has a higher DOL, which means plan
B is riskier than plan A.
A high degree of operating leverage implies
a high business risk. 高经营杠杆系数意味着高
经营风险。
Financial risk
Financial risk: an increase in
stockholders’ risk, over and above the
firm’s basic business risk, resulting
from the use of financial leverage.
 财务风险：是在公司基本经营风险的基础上股
东所面临的增加的风险，它源于公司对财务杠
杆的作用。



Business risk is the risk without the debt.
Financial risk is the risk with the debt.
Financial risk



Financial risk can also be measured by
financial leverage.
Financial leverage: the degree to which a
firm is utilizing borrowed money.
财务杠杆: 公司利用债务筹资的程度（比例）。
Financial leverage
Financial leverage is the ratio of
percentage change in EPS divided by
percentage change in EBIT.
 经营杠杆是每股收益变动百分比与息税前利润
变动百分比之间的比率。
 EPS

DFL 
EPS
 EBIT
EBIT

DFL (degree of financial leverage, 财务杠杆
系数)
Computing the DFL
DFL 
EBIT
EBIT - I
EBIT = Earnings before interest and taxes
I = Interest
Case study

Option 1: Zero debt (100% equity)
Debt ratio: 0%
 Total capital: $200,000
① Debt: 0
② Common equity: $200,000 ($20/share)
 Shares outstanding: 10,000 shares

Demand
Probability
EBIT
Terrible
0.05
-60,000
Poor
0.20
-20,000
Normal
0.50
40,000
Good
0.20
100,000
Wonderful
0.05
140,000
Case study


Expected EBIT=$40,000
I=0
EBIT
40,000
DFL
1


EBIT - I
40,000 - 0
1
Case study

Option 2: 50% debt (50% equity)
Debt ratio: 50%
 Total capital: $200,000
① Debt: $100,000 (interest rate=12%)
② Common equity: $100,000 ($20/share)
 Shares outstanding: 5,000 shares

Demand
Probability
EBIT
Terrible
0.05
-60,000
Poor
0.20
-20,000
Normal
0.50
40,000
Good
0.20
100,000
Wonderful
0.05
140,000
Case study


Expected EBIT=$40,000
I=$100,000×12%=$12,000
DFL
2

EBIT
EBIT - I

40,000
40,000 - 12,000
 1.43
Case study



DFL1=1, DFL2=1.43
Option 2 has higher DFL, also means option
2 has higher financial risk.
A high degree of financial leverage implies a
high financial risk. 高财务杠杆系数意味着高财
务风险。
Degree of Total Leverage (DTL)
 The percentage change in EPS that
results from a given percentage change in
sales.
DTL = DOL X DFL
DTL =
Q(P - V)
Q(P - V) - F - I
DTL =
S - VC
S - VC - F - I
=
=
Gross Profit
EBIT - I
EBIT + F
EBIT - I