Chapter 7
Leverage and Capital Structure
Leverage – portion of a business’s fixed cost that represents
a risk to the firm
 Operating Leverage – measure of operating risk
- Fixed operating costs found in the income
statement
 Financial Leverage – measure of financial risk
- Long term financing with fixed financing charges
of business’s assets
- Higher financial leverage = higher financial risk
and higher cost of capital
* Optimal structure for any business enterprise depends to a
great extent on the amount of leverage the business can
tolerate and the resultant cost of capital
S – Sales
x – Sales Volume per Unit
p – Selling Price per Unit
v – Unit Variable Cost
VC – Variable Operating Cost
FC – Fixed Operating Cost
A. Break-even Analysis – closely related to operating
leverage
- Determines *break-even sales [*financial crossover
point at which revenue exactly match costs]
- Important Concepts
 Contribution Margin (CM) – amount of money
available to cover fixed cost (FC) and generate
profits
- excess of sales (S) over the variable cost (VC)
= S – VC
 Unit CM – excess of unit selling price (p) over the
unit variable cost (v)
=p–v
a. Break-Even Point – level of sales revenue that equals
to the total of variable and fixed costs for any given
volume of output at a particular capacity use rate
- Lower BEP = higher profits and less operating
risk
- Break-Even Points in Units = fixed cost DIVIDED
BY unit CM
b. Cash Break-Even Point – necessary sales to cover all
cash expenses during the period
- Not all fixed operating cost involve cash payment
(e.g. depreciation)
- Usually lower than break-even point
= fixed cost MINUS non-cash charges
= (fixed cost MINUS depreciation) DIVIDED BY
unit CM
B. Operating Leverage – measure of operating risk
- Arises from the business’s use of fixed operating cost
- Simple indication = impact of a change in sales on
earning before interest and taxes (EBIT)
- Operating Leverage at a given Level of Sales (x) =
percent change in *EBIT DIVIDED BY percent change
in sales
(𝑝−𝑣)𝑥
= (𝑝−𝑣)𝑥−𝐹𝐶
- *EBIT = (p-v) x - FC
C. Financial Leverage – measure of financial risk
- Arises from the presence of debt and/or preference
share capital in business’s capital structure
- way to measure: determine how earning per share
(EPS) are affected by a change in EBIT
- If EBIT falls = financially leveraged business will
experience negative changes in EPS that are larger
than relative decline in EBIT
- Preference share divided must be adjusted for tax
- Financial Leverage at a given Level of Sales (x) =
percent change in EPS DIVIDED BY percent change in
EBIT
(𝑝−𝑣)𝑥 −𝐹𝐶
= (𝑝−𝑣)𝑥−𝐹𝐶−𝐼
* I = fixed finance charges
Total Leverage – measure of total risk
- To measure: determine how EPS is affected by a
change in sales
- Total Leverage at a given Level of Sales (x)
= percent change in EPS DIVIDED BY percent
change in sales
= operating leverage MULTIPLIED BY financial
leverage
(𝑝−𝑣)𝑥 (𝑝−𝑣)𝑥−𝐹𝐶
= (𝑝−𝑣)𝑥−𝐹𝐶
× (𝑝−𝑣)𝑥−𝐹𝐶−𝐼
(𝑝−𝑣)𝑥
= (𝑝−𝑣)𝑥−𝐹𝐶−1
Tools of Capital Structure Management
* Capital Structure Management – mix of long-term funding
source used by business
- To maximize market value of business
- Optimal Capital Structure – mix, minimizes the overall
cost of capital
o Not all financial managers believe that this actually
exists
o May allow a higher portion of debt to equity than
actual industry average = justify more debt than
industry
- Decision to use debt and/or preference share in
capitalization results in two types of financial leverage
effect
i. Increased risk to EPS caused by the use of financial
obligations
ii. Relates to the level of EPS at a given EBIT under a
specific capital structure
- Tools 1. Growth rate and stability of future sales
1. EBIT-EPS Analysis – practical tool that enables 2. Competitive structure in the industry
financial managers to evaluate alternative financing 3. Asset makeup of individual firm
plans by investing their effect on EPS for a range of 4. The business risk which the firm is exposed
EBIT levels 5. Control status of owners and management
- Primary objective: determine the EBIT break- 6. Lenders’ attitudes toward the industry and the business
even or indifference points at which the EPS will Factors that Affect the Level of Target Debt Ratio
be the same regardless of the financing plan Main: Business’s ability to service fixed financing costs
- EBIT amount > EBIT indifference level = more Other:
highly leveraged financing plan will generate a. Maintaining a desired bond rating
higher EPS b. Providing an adequate borrowing reserve
- EBIT amount < EBIT indifference level = financing c. Exploiting the advantages of financial leverages
plan involving least leverage will generate higher
EPS
(𝐸𝐵𝐼𝑇−𝐼)(1−𝑡)𝑃𝐷 (𝐸𝐵𝐼𝑇−𝐼)(1−𝑡)𝑃𝐷
= 𝑆1
= 𝑆2
2. Analysis of Cash Flow – to determine the ability to
service fixed charges
- Greater peso amount of debt and/or preference
share capital the business issues and the shorter
their maturity = greater fixed charges the
business will have to bear
- Before assuming additional charges, business
should analyze its future expected future cash
flows
o Inability to meet future charges = insolvency
- Greater and more stable expected future cash
flow = greater debt capacity
3. Calculation of Comparative Coverage Ratio –
corporate financial officer typically uses as EBIT as a
rough measure of the cash flow available to cover
debt-servicing obligation
- Can be used for two types of comparison
i. Can compare past and expected future
ratios for the same business in order to
determine if there has been improvement
or deterioration in coverage over time
ii. To evaluate capital structure of other
businesses in the same industry
- Common Ratios
a. Time Interested Earned – most widely used
comparative ratio
- Reveals nothing about business’s ability
to meet principal payments on its debt
= EBIT DIVIDED BY interest on debt
b. Debt-Service Coverage – coverage ratio for
full debt-service burden
𝐸𝐵𝐼𝑇
= 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡1 +
1−𝑇𝑎𝑥 𝑟𝑎𝑡𝑒
* Financial risk associated with leverage should be analyzed
of the business’s ability to service total fixed charges
* Lease financing is NOT a debt, but it has same impact on
cash flow.

Factors that Influence Capital Structure