Leverage and Capital Structure
-BY RAHUL JAIN
What’s the winning
combination
Financial Management, Ninth Edition © I M Pandey
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Chapter Objectives
 Explain the concept of financial leverage.
 Analyse the combined effect of financial and
operating leverage.
 Highlight the difference between operating
risk and financial risk.
 Finding Optimal capital structure
Financial Management, Ninth Edition © I M Pandey
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Capital Structure Defined
 The term capital structure is used to represent
the proportionate relationship between debt
and equity.
 The various means of financing represent the
financial structure of an enterprise. The lefthand side of the balance sheet (liabilities plus
equity) represents the financial structure of a
company. Traditionally, short-term borrowings
are excluded from the list of methods of
financing the firm’s capital expenditure.
Financial Management, Ninth Edition © I M Pandey
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Optimal capital structure
 Highest EPS indicates optimal capital
structure
 Lower risk levels
Financial Management, Ninth Edition © I M Pandey
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Questions while Making the Financing
Decision
 How should the investment project be financed?
 Does the way in which the investment projects are




financed matter?
How does financing affect the shareholders’ risk,
return and value?
Does there exist an optimum financing mix in terms
of the maximum value to the firm’s shareholders?
Can the optimum financing mix be determined in
practice for a company?
What factors in practice should a company consider
in designing its financing policy?
Financial Management, Ninth Edition © I M Pandey
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Meaning of Financial 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
financial leverage or gearing or trading on equity.
 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 rate of return on the owners’ equity is
levered above or below the rate of return on total
assets.
Financial Management, Ninth Edition © I M Pandey
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Measures of Financial Leverage




Debt ratio
Debt–equity ratio
Interest coverage
The first two measures of financial leverage can be
expressed either in terms of book values or market
values. These two measures are also known as
measures of capital gearing.
 The third measure of financial leverage, commonly
known as coverage ratio..
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
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Financial Leverage of Ten Largest
Indian Companies, 2002
Company
Capital Gearing
Income Gearing
Debt ratio Debt–equity ratio Interest coverage Interest to EBIT ratio
1. Indian Oil
0.556
1.25:1
4.00
0.250
2. HPCL
0.350
0.54:1
5.15
0.194
3. BPCL
0.490
0.96:1
5.38
0.186
4. SAIL
0.858
6.00:1
- ve
- ve
5. ONGC
0.106
0.12:1
53.49
0.019
6. TELCO
0.484
0.94:1
0.99
1.007
7. TISCO
0.577
1.37:1
1.62
0.616
8. BHEL
0.132
0.15:1
8.36
0.120
9. Reliance
0.430
0.75:1
3.46
0.289
10. L&T
0.522
1.09:1
2.31
0.433
11. HLL
0.027
0.03:1
264.92
0.004
12. Infosys
0.000
0.00:1
NA*
NA*
13. Voltas
0.430
0.72:1
2.64
0.378
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
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Financial Leverage and the
Shareholders’ Return
 The primary motive of a company in using financial
leverage is to magnify the shareholders’ return under
favourable economic conditions. The role of financial
leverage in magnifying the return of the shareholders’
is based on the assumptions that the fixed-charges
funds (such as the loan from financial institutions and
banks or debentures) can be obtained at a cost lower
than the firm’s rate of return on net assets (RONA or
ROI).
 EPS, ROE and ROI are the important figures for
analysing the impact of financial leverage.
Financial Management, Ninth Edition © I M Pandey
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Effect of Leverage on ROE and
EPS
Favourable
ROI > i
Unfavourable
ROI < i
Neutral
ROI = i
Financial Management, Ninth Edition © I M Pandey
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Operating Leverage
 Operating leverage
affects a firm’s
operating profit (EBIT).
 The degree of
operating leverage
(DOL) is defined as the
percentage change in
the earnings before
interest and taxes
relative to a given
percentage change in
sales.
 DOL=
Contribution/EBIT
 Higher DOL
indicates Higher
Operating risk
Financial Management, Ninth Edition © I M Pandey
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Financial Leverage
 DFL= EBIT/EBT
 Higher DFL indicates Higher
financing risk
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
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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
leverages is combined to see the effect of
total leverage on EPS associated with a
given change in sales.
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
14
Combining Financial and Operating
Leverages
 Combined Leverage= Contribution/EBT
 Higher Leverage indicates higher risk
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
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References
 Financial Management- I.M. Pandey
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
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