Corporate Finance –
LECTURE 12
CAPITAL STRUCTURE AND FINANCIAL LEVERAGE
In this hand out we shall cover the following topics:
 When to use WACC?
 Pure Play
 Capital Structure and Financial Leverage
WHEN TO USE WACC:
As we have covered in our lecture that using WACC as discount rate for discounting the cash
flow of intended project, is only feasible if the proposed project fall within the firms existing
activities circle. For example if a Oil manufacturing concern plans to establish another
production facility then the existing WACC of the firm can be used as discount rate.
However, if the same firm is thinking to set up a new spinning unit, then using existing
WACC would be fatal and inappropriate.
WACC of a company reflects the level of risk and WACC is only appropriate discount rate if
the intended investment is replica of company’s existing activities – having same level of risk.
Using WACC as discount rate when the intended project has different risk level as of company
then it will lead to incorrect rejections and/or incorrect acceptance.
For example, a company having two strategic units and one unit having lower risk than the
other, using WACC to allocate resource will end up putting lower funds to high risk and
larger funds to low risk division.
The other side of this issue emerges from the situation when a firm is having more than one
line of business. For example a firm has two divisions: one of these has relatively low risk and
the other has high risk.
In this case, the firm’s overall WACC would be the sum of two different costs of capital, which
is one for each business division. If two of these are contenders for the resources, the riskier
division would tend to have greater returns so it would be having the major chunk. The other
one might have huge profit potential ends up with insufficient resources allocated.
Pure Play
Using WACC blindly can lead to severe problems for a firm. Because we cannot observe the
returns of these investment, there generally is no direct way of coming up with the beta. The
approach must be to find a project or another firm in the industry in which our proposed project
falls. We can use the beta of that firm along with the D/E ration prevalent in that industry.
Once we have the beta and D/E of the firm or industry that resembles to our project we can
estimate the exact beta and D/E of proposed project. For example, if the industry (in which our
intended project will fall) has a beta of 1.7 and D/E ratio of 40:60, and we intend to finance the
new project through equity only, we can calculate the exact beta of intended project which, in
turn will be used to calculate the new project WACC or discount rate to evaluate the project
cash flow. This process may involve un-gearing and re-gearing.
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Formula to un-gear equity Beta = Gbeta x (E / E + D(1-t))
Gbeta = Geared beta (1.7 in our example)
E
= Weight of equity in capital structure
D
= Weight of debt in capital structure
T
= Tax rate
In this example we need to un-gear the beta. Why? Note that the beta of the industry in which
the proposed project falls has D/E ratio of 40:60 but the new project shall be all equity financed.
We un-gear the beta – that means the financial risk element needs to be removed from the
geared beta of 1.7.
If we plug in values in the above equation we get the value of un-geared beta of 1.3296,
which is also WACC as there is no debt. This should be used as discount rate to evaluate
future cash flow of proposed project.
Pure play refers to what has been described above. We need to gauge the systematic risk of the
new project in order to calculate the beta and WACC to be used for discounting cash flow.
Capital Structure & Financial Leverage:
FOR the most part, a firm may choose any capital structure. Capital structure refers to the
combination of financing through equity and loans or debt. If management might decide to
issue new shares and pay off bond debt in order to reduce the debt-equity ratio. Activities like
this are known as capital restructuring.
This is in fact a change of investment source leaving the firm’s assets unchanged.
In the last 4/5 lectures we discussed the concept of WACC. It is simply the firm’s overall cost of
capital and comprised of weighted average of the costs of various components of firm’s capital
structure. Now the question arises that what happens to cost of capital when we change the
relative weights of debt or equity?
The value of firm is maximized when WACC is at its lowest level. As you know that WACC is
the discount rate appropriate to evaluate the cash flow, the lower the discount rate the higher the
present value of cash flow. In other words, present value and discount rate move in opposite
direction, lower WACC will ensure maximizing the cash flow of the firm.
Thus, a firm must choose the capital structure so that the WACC is minimized. A capital
structure that minimizes the WACC would be better than the other one which with higher
WACC.
Financial Leverage
The amount of debt in capital structure of a firm is known as financial leverage. In other words,
how a firm utilizes the amount of debt. The more debt in capital structure, there is greater
financial leverage.
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Financial leverage magnifies the payoffs to shareholders. It means that it increases the profit and
loss with more percentage than a percentage change in sales. It may be possible that financial
leverage does not affect the cost of capital. It is true then firm capital structure becomes
irrelevant.
For example, a firm is all equity financed. Total assets are ksh. 6.0 million which are finance by
200,000 shares of Ksh. 20 each. It is assumed that EBIT (Earnings before Interest & Tax) is
Ksh. 800,000 in first year and Ksh. 1.20 million in second year. In this case, EPS (Earning per
share) will be Ksh. 2.67 & Rs.4 per share respectively in first and second year. The ROE
(Return on Equity) is 13.33% and 20% respectively for year 1 & 2.
Now consider that the firm decides to employ debt in it capital structure. The asset side will
remain constant at Ksh. 6.0 million. In the proposed restructuring the D/E ratio of 1 is applied.
It means that Ksh. 3 million will be invested from equity and Ksh. 3 million of debt is
employed. Interest rate is assumed at 10%. Assuming the same level of EBIT in both years, the
EPS is now Ksh. 3.33 and Rs.6 and ROE has jumped to 16.67% and 30% in first and second
year respectively.
This magic is played by the financial leverage. It has increased both EPS AND ROE after debt
was mixed up in the capital structure.
Y
EP
S
DEBT
NO DEBT
BE
+ FIN LEVERAGE
2
X
300000
600,0
00
EBIT
-2
-IVE FIN LEVERAGE
Financial leverage can also increase the losses as well. Looking at the graph above, if the
EBIT is not enough then it magnifies the losses. At EBIT of Ksh. 600,000 the EPS is Ksh. 2/. If the EBIT is less than point BE it represents the negative impact of debt. If the EBIT is
falling right to the BE point it increase the return, the positive financial leverage.
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