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. Optimal Capital Structure : Optimal capital structure is the one that strikes a balance between risk & return to achieve ultimate goal of maximizing the price of the stock. # Four primary factors influence the capital structure decisions 1. Business Risk (BR) : The firms BR , or riskiness that would be inherent in the firms operations if it is used no debt. The greater the firms business risk, the lower the amount of debt that that is optimal. 2. Tax position : A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt. 3. Financial Flexibility : The ability to raise capital on reasonable terms under adverse conditions. 4. Debt determining factor has to do with managerial attitude (conservatism or aggressiveness) with regard to borrowing . Some firms are more inclined to use debt in an effort to boost profits.

## Business risk : is defined as the uncertainty inherent in

projections of future returns, either on assets or on equity (ROE) , if the firm use no debt .

## Financial risk : The portion of stockholders risk ,over and above basic business risk, resulting from the manner in which the firm is financed. Financial risk results from using financial leverage, which exists when a firm uses fixed income securities, such as debt and preferred stock , to raise capital. ## Degree of Operating Leverage (DOL) is defined as the percentage change in operating income (EBIT) associated with a given percentage change in sales. DOL is concerned with the upper portion of the Income Statement. DOL Q = Q ( PV )____ Q(PV)F DOL S = S VC___ = Gross Profit S VC F EBIT

Degree of Financial Leverage (DFL) : The percentage change in earnings available to common stockholders associated with a given percentage in earnings before interest and taxes. DFL is concerned with lower part of the Income Statement . DFL indicates about the proportion of fixed financial obligation exists in the firms operation DFL = Percentage change in EPS EPS = EBIT___ EBIT I

# Degree of Total Leverage : The percentage change in EPS that results from a given percentage change in sales ;DTL shows the effects of both operating leverage and financial leverage. DTL = ( DOL) X ( DFL ) Q (P V )__ Q (P-V) F- I DTL = ___S VC___ = Gross Profit S VC F- I EBIT - I DTL = NOTE : I VC F S = = = = Interest Variable Cost Fixed Cost Sales

MATH Capital Structure , effect of debt on the EPS Given the following information, calculate (i) the Earnings Per Share (EPS) and (ii) Expected Earnings Per Share (iii) Degree of Operating Leverage (DOL) (iv) Degree of Financial Leverage (DFL) of ABC Company for 2002 if : (i) Debt / Assets = 0%, (ii) Debt / Assets = 50% Probability of Indicated sales Sales (thousand) Fixed Cost (thousand Variable Cost (thousand Total Cost (Except Interest) EBIT 0.2 $ 200 (80) (120) (200) 00 0.6 0.2 $400 $600 (80) (80) (240) (360) (320 ) (440) 80 160

Assume the following: (I)The firm is in the 40 percent tax bracket (ii)Cost of debt is 12 percent (iii)The value per share of ABC Company is $ 20 (iv)Total Capital of ABC Company is $ 200000