FINANCIAL STRUCTURE AND LEVERAGE CHAPTER-4

Financial Structure
Financial structure is the capitalized part of a firm's total financing which includes only the long-term sources such as long-
term debt and equity. To meet the capital requirement, a firm can use different sources. The combination of all these sources
along with the proportion of each source used by a firm is known as financial structure. It is a permanent financing of the firm.
In other words, financial structure of a firm refers to the mix of long-term sources of funds, such as debentures, long-term debt,
preference share capital and equity share capital including reserve and surpluses. The optimal financial structure is the
combination of proportions that maximize the total value of the firm and minimize the cost of capital.

Leverage
The degree to which a firm locks itself into fixed costs and financial costs is referred to as leverage position. The more highly
leveraged a firm, the riskier it is because of the obligations related to fixed costs that must be met whether the firm is having a
good year or not. At the same time, the more highly leveraged the greater the profits during good times.
There are three types of leverage in most business firms: operating leverage and financial leverage. They are mentioned below:
A. Operating Leverage
Operating leverage in a firm is a function of three factors: fixed cost, variable contribution margin, and the volume of sales.
Operating leverage results when fluctuations in sales revenue produce a wide change in operating profit (EBIT). So, operating
leverage refers to the use of fixed costs in the operation of a firm. The degree of operating leverage depends upon the amount
of fixed elements in the cost structure.
Degree of Operating Leverage (DOL)
The degree of operating leverage may be defined as the percentage change in earnings before interest and taxes resulting from
a percentage changes in sales. It can be expressed in the following way:
Percentage change in EBIT
DOL = Percentage change in Sales
EBIT Sales
= EBIT  Sales
Alternatively, degree of operating leverage can be computed by dividing contribution margin by earning before interest and
taxes. It can be expressed in the following way:
Contribution Margin
DOL = Earning Before Interst and Taxes
CM
= EBIT
Q (S – V)
= Q (S – V) – FC
Where, Q = Quantity
S = Selling Price Per Unit
V = Variable Cost per Unit
If break-even point in units (QBE) is known, then the degree of operating leverage can be determined by using following
formula:
Q
DOLQ = Q – Q
BE
B. Financial Leverage
Financial leverage is the ratio of net return on the shareholder's equity and the net return on the total capitalization. It
indicates the effect on earnings created by the use of fixed charge securities in the capital structure. It results from the use of
funds with the fixed rate of return.
Degree of Financial Leverage (DFL)
The degree of financial leverage is the numerical measure of the firm's financial leverage. Computing it is much like
computing the degree of operating leverage. The following equation presents one approach for obtaining the Degree of
financial leverage (DFL).
Percentage change in EPS
DFL = Percentage change in EBIT
EPS EBIT
= EPS  EBIT

Degree of financial leverage can also be founded as:

Percentage change in EBT
DFL = Percentage change in EBIT
EBT EBIT
= EBT  EBIT
Alternatively, degree of financial leverage can be computed by dividing earning before interest and taxes by earning before tax.
It can be expressed in the following way:
 EBIT
DFL = EBT
Where, EBT = EBIT – I
A more direct formula for calculating DFL is:
EBIT
DFL = Pd
EBIT - I - (1 – t)
Where, I = Interest on debt
Pd = Preferred dividend
C. Combining Operating and Financial Leverage
The combination of operating and financial leverage is known as combined leverage or total leverage. The combined effect of
operating and financial leverage measures their interaction on a firm. Thus combined leverage or total leverage can be defined
as the potential use of fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm's earning
per share. It can, therefore be viewed as the total impact of the fixed costs in the firm's operating and financial structure.
Degree of Combined Leverage (DCL)
The degree of combined leverage is the numerical measure of the firm's total leverage. The degree of combined effect of
operating and financial leverages can be determined by multiplying these two leverages. It can be expressed in the following
way: Degree of combined leverage (DCL) = DOL × DFL

Percentage change in EBIT Percentage change in EPS

Or, DCL = Percentage change in Sales x Percentage change in EBIT

Degree of combined leverage is the percentage change in earning per share resulting a percentage change in sales. It can be
expressed in the following way:
Percentage change in EPS
DCL = Percentage change in Sales
Alternatively, degree of combined leverage is the percentage change in earning before taxes resulting a percentage change in
sales. It can be expressed in the following way:
% change in EBT
DCL = % change in Sales
Contribution Margin CM
Alternatively, DCL = Earning Before Tax = EBT

Financial Leverage and Risk

Risk created as a result of financing decision is financial risk. Financial risk is associated with the creation of fixed obligation
to the firm by using debt element in the capital structure. Financial risk is introduced by the use of financial leverage. Thus,
financial risk is the additional risk placed on the common stockholder as a result of the decision to finance with debt. Financial
leverage and financial risk has positive relation. As financial leverage increases, the financial risk also increases. But it
increases shareholder's return.

Financial Leverage and Equity Risk

Financial leverage measures the degree of the use of debt and other fixed cost sources of funds to finance the assets the firm
has acquired. The use of debt has a magnifying effect on the earnings of a company. It can be said that the higher the portion
of debt in the financial structure, the higher the financial leverage.
Financial leverage can be measured by a simple ratio of debt to equity. The equity risk refers to the risk of the firm not being
able to earn according to the required rate of equity holders. When the firm is not able to cover its fixed financial cost, there
will be loss to equity holder which is called equity risk. The company can change its financial structure by issuing more and
more debt and using the proceeds to buy back equity. From this practice there is a significant impact on the return on equity.

Investment and Leverage

In real world decision making, it is often necessary to perform an analysis in which alternative leverage structures are
considered along with financing that increases the firm's amount of investment and size of total assets. When the company's
investment increases due to expansion of sales, a choice between debt issue and equity issue arises for the finance of new
investment. The usefulness of degree of combined leverage lies in the fact that it indicates the effect that sales changes will
have on earning per share (EPS). Its potential is also great in the area of choosing financial plans for new investments. If, for
example, the firm begins to invest heavily in more risky assets than usual, the firm's operating leverage will obviously incr ease.
If the firm does not change its financing policy, i.e. the firm's capital structure remains constant; there would be no change in
its financial leverage.
As a result, the firm's combined leverages would increase causing an increase in its total risk. The firm, in order to keep its
risk constant, may like to lower in financial leverage. This could be done if the new investments are financed with more equity
than the firm had used in the past. It would lower the financial leverage and compensate for the increased operating leverage
caused by investment in more risky investments. If the operating leverage has decreased due to low fixed costs, the firm can
afford to have a more levered financial plan in order to keep the total risk constant and at the same time having the same
prospect of magnifying effects on earning per share due to change in sales.
Factors Affecting Financial Structure Decisions
Financial structure decision is affected by the several factors. Some factors affecting financial structure decision are as follows:
1. Growth Rate of Sales: The future growth rate of sales is a measure of the extent to which the earnings per share of a firm
are likely to be magnified by leverage. If sales and earnings are growing at a favorable rate the stock price will be high.
Financing by debt with limited fixed charge should magnify the returns to owners of the stock in case of leveraged
situation but financing by equity is benighted in case of growing sales and earnings.
2. Cash flow stability: Cash flow stability and financial structure are directly related. A firm can incur the fixed charges of
debt if it has greater stability in sales and operating earnings. When operating cash flow is low, the firm may have
difficulty meeting its fixed interest obligations. Therefore, financial structure of a firm is affected by cash flow stability.
3. Industrial Characteristics: Debt serving ability is dependent on the profitability and volume of sales. In competitive
market more and more firm enter in the industry due to stability of profit margin. The capacity of the existing and new
firm grows at an increase rate. As a consequence, profit margin declined. Thus, the financial structure is affected.
4. Investor’s attitudes: Attitude of investors also affects financial structure of a firm. Some investors may prefer only
debenture or preference share. On the other hand, some may prefer only ordinary share. Hence, different types of securities
should be issued to raise fund by attracting all types of lenders and investors. In this way, financial structure of the firm
depends on the attitudes of investors.
5. Management attitudes: The management attitudes that directly influence the financial structure of the firm because they
are concerned about the control of the firm and risk. Big firms whose stock is widely owned may choose additional sales of
common stock because such sales will have little influence on the control of the management. In contrast, if the shares are
closely held (i.e. limited number of shareholder), management likes to maintain existing structure of shareholders. For this
it uses debt instead of equity capital. Hence, not to lose the control, they try to raise capital from debt instead of shares.
The financial structure also depends on the age experience, and the tendencies like ambition, self-confidence, etc. of the
management.
6. Lender attitudes: Lender is also one of the determinants of financial structures. The firm discusses with lender about the
financial structure and gives much consider to their advice. Lender emphasizes the excessive debt reduces the credit
standing of the borrower and the credit rating of the securities previously issued.
7. Asset structure: Asset structure also influences the financial structure decision of a firm. The firm having assets of long-
life and steady demand for goods and earning may use long-term source financing in financial structure. On the other
hand the firm having predominance of short-term assets may rely more on short-term debt rather than long-term
financing.
8. Rate of return: The rate of return of the firm also affects its financial structure. If the firm is earning high rate of return,
it can depend to the greater extent on internal sources for its expansion. But if the rate of return is low, it is necessary to
depend on external source of finance.
9. Trends in capital market: The capital market determines the interest rate, dividend rate, etc. Hence, what types of
securities are to be issued depends on the situation of the capital market. What types of financial structure are to be made
depends on this relative costs, risks involved in different securities, investors' preferences for securities, etc. Before making
capital structure decision, a firm should have to observe whether the capital market is favorable or not, what kinds of
trends are going on in the capital market.
10. Economic policies: Economic policies of the government are also the main factors, which affect the financial structure
decision of the firm. The government affects the finance by regulation and taxation.