CHAPTER FIVE

FINANCING DECISIONS
if the weights of capital structure changed, the calculated cost of capital and thus the set of
acceptable projects, also will change. Further changing the capital structure will affect the
riskiness of the firm's common stock, and this will affect K s and Po. Therefore, the choice of a
Financing decision is an important issue.
5.1 THE TARGET CAPITAL STRUCTURE
A firm analyzes a number of factors, and then it establishes a target capital structure. This target
may change over time as conditions vary, but at any given moment the firm’s management has a
specific capital structure in mind. If the actual debt ratio is become the target level, expansion
capital will probably be raised by issuing debt, whereas if the debt ratio is above the target,
equity will probably be used.
FACTORS IN CAPITAL STRUCTURE DECISIONS
Firms generally should consider the following factors which influence capital structure decisions.
1. Sales stability: - A firm whose sales are relatively stable can safely take on more debt and
incur higher fixed charges than a company with unstable sales.
2. Asset structure: - Firms whose assets are suitable as security for loans tend to use rather
heavily. General purpose assets which can be used by many businesses make good collateral,
whereas special-purpose assets do not. Thus, real estate companies are usually highly leveraged,
whereas companies involved in technological research employ less debt.
3. Operating leverage: - Other things the same, a firm with less operating leverage is better able
to employ financial leverage because, as we saw, the interaction of operating and financial
leverage determines the overall effect of a decline in sales on operating income and net cash
flow.
4. Growth rate: - Other things the same, faster-growing firms must rely more heavily on
external capital.
5. Profitability: - One often observes, that firms with very high rates of return on investment use
relatively little debt. Although there is no theoretical justification for this fact, one practical
explanation is that very profitable firms simply do not need to do much debt financing. Their
higher rates of return enable them to do most of their financing with retained earnings.

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6. Taxes: - Interest is a deductible expense, and deductions are most valuable to firms with high
tax rates. Hence, the higher a firm’s corporate tax, the greater the advantage of debt.
7. Control: - The effect of debt versus stock on management’s control position can influence
capital structure. If management currently has voting control (over 50 percent of the stock), but
is not in a position to buy any more stock, it may choose debt for new financing. One the other
hand, management may decide to use equity if the firm’s financial situation is so weak that he
use of debt might subject it to serious risk of default because, if the firms gores into default, the
mangers will almost surely lose their jobs.
8. Management attitudes: - Since no one can provide that one capital structure will lead to
higher stock prices than another, management can exercise its own judgment about the proper
capital structure. Some management tend to be more conservative than others, and thus use less
debt than the average firm in their industry, whereas aggressive management use more debt in
the quest for higher profits.
9. Lender and rating agency attitude: - Regardless of managers own analyses of this proper
leverage factors for their firms, lenders and rating agencies attitudes frequently influence
financial structure decisions. In the majority of the cases, the corporations discusses its capital
structure with lenders and rating agencies and gives much weight to their advice.
10. Market conditions: - Conditions in the stock and bond market undergo both long-and short-
run changes that can have an important bearing on a firm’s optimal capital structure.
11. The firm’s internal conditions: - A firm’s own internal condition can also have a bearing on
its target capital structure.
12. Financial flexibility: - maintaining financial flexibility, which from an operational view
point, means maintaining adequate reserve borrowing capacity. Determining an “adequate”
reserve borrowing capacity is judgmental, but it clearly depends on the factors mentioned
previously in the unit, including the firm forecasted need for funds, predicted capital market
conditions, management’s confidence in its forecasts, and the consequences on a capital
shortage.
Capital structure policy involves a trade-off between risk and return:
 Using more debt raises the riskiness of the firm’s earnings stream
 However, a higher debt ratio generally leads to a higher expected rate of return

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Higher risk tends to lower a stock’s price, but higher expected rate of return raises it. Therefore,
the optimal capital structure strikes a balance between risk and return so as to maximize a firm’s
stock price.
These four points larger determine the target capital structure, but operating conditions can
cause the actual capital structure to vary from the target.
5.2 THE CONCEPT OF LEVERAGE
The leverage concept is very general. It is not unique to business or finance, and it can be used to
analyze many different types of problems. For example, other disciplines, such as economics and
engineering, use the same concept, and refer to it as elasticity. When used in a financial setting,
leverage measures the behavior of interrelated variables, such as output, revenue, earnings before
interest and taxes (EBIT), and earnings per share (EPS).
The material in this chapter will be easier to understand if two points are kept in mind.
1. Leverage measures the relationship between two variables, as opposed to measuring
variables independently, and the value that one variable assumes must depend on the
values assume by the second variable.
2. In order for leverage coefficients to have any useful applications, it must be possible to
identify which variable is the dependent variable. In other words, the direction of casualty
must be known. When two variables are so related, the degree of leverage describes the
responsiveness of the dependent variable to change in the independent variable.
Let Y and X represent two variables. When the values taken by Y are determined by the values
taken by X, Y is said to be dependent on X. accordingly, Y is called the dependent variable and
X is referred to as the independent variable. The algebraic statement of Y’s dependence on X is
written as:
Y = f (x)
And is read as: Y is a function of X
Suppose that the initial values of Y and X are known. The independent variable X now takes on
a new value. The change in the value of X and its percentage change are computed. The resulting
change and percentage change are also computed. Leveraged is then defined as the percentage
change in the dependent variable Y divided by the percentage change in the independent variable
X. in algebraic terms, the definition of leverage is developed as follows:
Let x = the change in the independent variable x

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 y = the change in the dependent variable y.
Δx
x = the percentage change in x = % x
Δy
y = the percentage change in y = % y
Then,
L ( y ) Δy / y
=
L ( x ) Δx /x
The left hand side of the above equation is read as: the leverage of y with respect to x.
5.2.1 Operating Leverage
Operating Leverage measures the relationship between output and earnings before interest and
tax (EBIT), specifically; it measures the effect of changing levels of output on EBIT. The
functional relationship between these two variables is:
y = f (T),
Where, y = earnings before interest and tax
T = number of units of output produced and sold

Earnings before interest and tax = Total revenue – Total variable cost – fixed cost.

When the level of output changes from its initial value, the initial value of EBIT also changes.
Thus, operating leverage is defined as the resulting percentage change in EBIT divided by the
percentage change in output, symbolically, operating leverage is expressed as:
L ( y) Δy/ y % Δ EBIT
= =
L (T ) ΔT /T % Δ output
Example: Assume that the price per unit of output (p) is Br. 10, and variable cost per unit of
output (y) is Br. 4, and fixed cost (F) is Br. 30,000, and the level of output (T) is 8000 units. By
using the formula EBIT is computed as follows:
y = Total revenue – Total variable cost – fixed cost
y = TP – TV – F
or y = T (P – V) – F
y = 8000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 18,000

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Now assume that the level of output increases from 8000 to 10,000 units. The resulting EBIT is
computed as:
y = 10,000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 30,000
The coefficient of operating leverage is computed as follows:
Percentage change in output = 2000/8000 = 25%
Percentage change in EBIT = Br. 12000/Br. 18000 = 66.7%
L( y ) Δy/ y
=
L (T ) ΔT /T
L ( y ) . 667
=
L (T ) . 25 = 2.67
The coefficient of operating leverage of 2.67 is interpreted as follows. A 1 percent change in
output from an initial value of 8000 units produces a 2.67 percent change in EBIT. Since output
increased by 25 percent from its initial value of 8000 units, EBIT increases by (2.67) (.25) = .667
or 66.7 percent.

Measurement equations equivalent to the definitional equations are used to compute and to
explain the properties of operating leverage. The measurement equation used when the income
statement relationship is describes as follows:
T (P−V )
(OL/T) = T ( P−V ) − F
The left hand side of the equation is read as: operating leverage, given the value of output.
B1 putting the date of the previous example the above equation can be illustrated as follows:
8000 (Br .10−Br . 4 )
= 2 . 67
(OL/T = 8000) = 8000 (Br .10−Br . 4 )−30 , 000
Properties of Operating Leverage
The properties of operating leverage determine its use and a tool of financial analysis. These
properties are best explained by using operating breakeven and EBIT, operating breakeven is
defined as the value of output that makes EBIT equal to zero. At this level of output, total
revenue is just sufficient to pay operating variable and fixed costs, and no earnings are available
to cover financial costs, when output exceeds operating breakeven, the total revenue that is

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generated provides a positive level of EBIT; below operating breakeven, the firm incurs an
operating loss. The operating breakeven is expressed as follows:
T (P – V) – F = 0
and solving for T yields
F
T = P−V
Example – Assume that P = Br. 25, V = Br. 10, and F = Br. 60,000. Operating breakeven is
calculated as follows:
Br.60,000
= 4000 units
T = Br .25 − Br.10
If operating leverage is calculated at operating breakeven, the coefficient of operating leverage
would be:
4000 (Br .25−Br .10)
=
4000 (Br .25 − Br .10 ) − 60 ,000
Br .60 ,000
= = undefined
(OL/T = 4000) 0
Note that the coefficient of operating leverage at operating breakeven has undefined value, not a
value of zero.
Interpretations of operating leverage
 Fundamental interpretation: - The percentage change in EBIT that results from a given
percentage change in output it equal to the value of operating leverage at the initial value
of output multiplied by the percentage change in output.
 Related interpretations: -
1- A positive coefficient of operating leverage indicates that the leverage is
being computed at a level of output greater than operating breakeven.
2- A negative coefficient of operating leverage indicates that leverage is being
computed at a level of output below operating breakeven
3- A large absolute value of operating leverage (the coefficient of operating leverage
without regard to its algebraic sing) indicates that output is close to operating
breakeven and that the absolute size of EBIT is relatively small

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 4- A positive coefficient of operating leverage close to 1.0 indicates that output is
relatively far above operating breakeven and that the amount of EBIT is relatively
large.
5- If a high percentage of a firm’s total costs are fixed, the firm is said to have a high
degree of operating leverage.
A high degree of operating leverage, other things hold constant, means that a
relatively small change in sales will result in a large change in operating income.
5.2.2 Financial Leverage

Financial leverage measures the relationship between EBIT and earning per share (EPS).
Specifically, it reflects the effect of changing levels of EBIT on EPS. The functional relationship
between these two variables is:
EPS = f (EBIT)
and the income statement relationship is: -
Profit before taxes:
EBIT – interests on debt = Y – I
Federal income taxes:
(profit before taxes) (tax rate) = (Y – I) (t)
profit after tax:
profit before taxes – federal income taxes
(Y – I) – (Y – I) (t) or
(Y – I) (1 – t)
Earnings available to common shareholders
profit after taxes – preferred stock dividends
(Y – I) (1 – t) – E
Earnings per share of common stock:
Earnings available to common shareholders
number of common shares issued
EPS = (Y – I) (1 – t) – E
N

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The algebraic equivalent of the complete income statement is obtained by substituting the
symbolic form of EBIT as follows:
[ T ( P − V ) − F − I ] (1−t ) −E
EPS = N

When the level of EBIT changes from its initial value, the initial value of EPS also changes.
Financial leverage is thus defined as the resulting percentage change in EPS divided by the
percentage change in EBIT. Symbolically, financial leverage is expressed as:
L ( EPS ) Δ EPS/ EPS % Δ EPS
= =
L ( EBIT ) Δ EBIT / EBIT % Δ EBIT

Note that EBIT is the independent variable when measuring financial leverage, but the dependent
variable when measuring operating leverage. As a result, EBIT, is sometimes called the linking
pin variable with respect to leverage application in finance.
Example Assume that I = Br. 100,000, t = 0.4, E = Br. 80,000
N = 60,000, and EBIT = Br. 500,000. the EPS at this level of EBIT is
computed as:
EPS = (Br. 500,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 2.67
If EBIT increases from Br. 500,000 to Br. 600,000, the resulting EPS is:
EPS = (Br. 60,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 3.67
The financial leverage is computed as:
Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20%
Percentage change in EPS = Br. 1/Br. 2.67 = 37.45%
L ( EPS ) 0 . 3745
= = 1 . 87
L ( EBIT ) 0.2
The coefficient of financial leverage of 1.87 is interpreted as follows: A 1 percent change in
EBIT from an initial value of Br. 500,000 produces a 1.87 percent change in EPS. Since EBIT

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increased by 20 percent from its initial value, EPS increased by 1.87 (0.20) = 0.374 or 37.4
percent.
The measurement equation used to compute the coefficient of financial leverage when the
income statement relationship is:
Y
E
Y−I −
(FL/Y) = 1−t
The left hand side of the above equation is read as: financial leverage, given the value of EBIT.
By putting the data of the pervious example, equation is illustrated as:
500 , 000
= 1. 88
Br . 80,000
Br .500 , 000−Br .100 ,000−
(FL/Y = Br. 500,000) = 1 − 0. 4
Financial leverage is sometimes called balance sheet leverage or capital structure leverage.
Properties of financial leverage
The properties of financial leverage can be explained by using the concept of financial
breakeven. Financial breakeven is defined as the value of EBIT that makes EPS equal to zero. At
financial breakeven the firm’s EBIT, the form produces a positive level of earnings available to
common shareholders and a positive EPS. Below this level, profit available to common
shareholders and EPS are both negative. It is thus possible for a firm to earn a positive level of
EBIT even though its EPS is negative. This will happen when the firm’s EBIT is positive but less
than its financial breakeven level. Financial breakeven is expressed as:
(Y −I ) (1 − t )−E
=0
N
Solving this equation for Y, or EBIT, yields:
E
Y = I + 1−t
Example – Assume I = Br. 2,000,000 and E = Br. 1,300,000. Financial breakeven is calculated
as: Assuming 40% tax rate.
Y = Br. 2,000,000 + Br. 1,300,000 / (1 – 0.4) = Br. 4,166,667

If financial leverage is calculated at financial breakeven, the resulting coefficient of financial

leverage has an undefined value, computing by using the above equation:

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 Br .4 ,166,667
(FL/Y =Br .4,166,667)=
Br .4 ,166,667−Br .2,000,000−Br .1,300,000/(1−0.4)
Br .4 ,166,667
= = undefined
0
Interpretations of financial leverage

 Fundamental interpretation: the coefficient of financial leverage is the percentage change

in EPS that results from a 1 percent change in EBIT.
 Related interpretations:
1. A positive coefficient of financial leverage means that leverage is being computed for a
value of EBIT that is greater than financial breakeven.
2. A negative coefficient of financial leverage indicates that leverage is being computed for
a value of EBIT below financial breakeven
3. A large absolute value of financial leverage indicates that leverage is being computed
close to financial breakeven and that the absolute value of EPS is relatively small.
4. A positive coefficient of financial leverage close to 1.0 indicates that leverage is being
computed for a value of EBIT that is relatively far above financial breakeven and that the
corresponding value to EPS is relatively large.
5. Financial leverage refers to the use of fixed-income securities-debt and preferred stock.
5.3. CAPITAL STRUCTURE THEORY

Capital structure theory has been developed along two main lines
- Tax benefit bankruptcy cost trade-off theory
- Signaling theory
Trade-off theory
Modern capital structure theory begins in 1958, when professors Franco Modigliani and Merton
Milles (hereafter MM) published what has been called the most influential article ever written.
MM proved, under a very restrictive set of assumptions, that because of the tax deductibility of
interest on debt, a firm’s value rises continuously as it uses more debt, and hence its value will be
maximized by financing almost entirely with debt. MM’s assumptions included the following:
1. There is no brokerage costs
2. There is no personal taxes

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 3. Investors can borrow as the same rate as corporations
4. Investors have the same information as management about the firm’s future investment
opportunities
5. All the firm’s debt is riskless, regardless of how much debt of uses
6. EBIT is not affected by the use of debt.
Since several of these assumptions were obviously unrealistic, MM’s positions was only the
beginning of capital structure research.
Subsequent researchers, and MM themselves, extended the basic theory by relaxing the
assumptions. Other researchers attempted to test the theoretical model with empirical data to see
exactly how stock prices and capital costs are affected by capital structure. Both the theoretical
and empirical results have added to our understanding of capital structure, but none of these
studies has produced results that can be used to identify precisely a firm’s optimal capital
structure. A summary of the theoretical and empirical research are the following.
1. The fact that interest is deductible expense makes debt less expensive than common or
preferred stock. That is debt provides tax shelter benefits. As a result, using debt causes
more of the firm’s operating income (EBIT) to flow through to investors, so the more
debt a company uses, the higher its value and the higher the price of its stock.
2. The MM assumptions do not hold in the real world. First interest rate rises as the debt
ratio rises. Second, EBIT declines at extreme level of leverage. Third, expected tax rate
fall at high debt levels, and this reduces the expected value of the debt tax shelter. And,
fourth, the probability of the bankruptcy, which brings with it lawyers’ fee and other
costs, increases as the debt ratio rises.
3. Both theory and empirical evidence support the preceding discussion. However,
statistical problems prevent researchers from identifying points of threshold debt level
where bankrupt costs become material and optimal capital structure – where marginal tax
shelter benefits and marginal bankruptcy – related costs are equal.
4. Another disturbing aspect of capital structure theory is the fact that many large,
successful firms use far less debt then the theory suggests. This point led to the
development of signaling theory.

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Signaling Theory
MM assumed that investors have the same information about a firm’s prospects as its managers –
this is called symmetric information. However, managers often have better information than
outside investors. This is called asymmetric information, and it has an important effect on the
optimal capital structure. To see why, consider two situations, one in which the company’s
managers know that its prospects are extremely favorable (Firms F), and one in which the
mangers know that the future looks unfavorable (Firm U).
Suppose, for example, that Firm F’s have just discovered a nonpatentable cure for the common
cold. They want to keep the new product a secret as long as possible to delay competitors’ entry
into the market. New plant must be built to make the new product, so capital must be raised.
How should Firm F’s management raise the needed capital? If the firm sells stock, then, when
profits from the new product start flowing in, the price of stock will rise sharply, and the
purchasers of the new stock will have made a bonanza. The current stockholders (including the
managers) will also do well, but not as well as they would have done of the company had not
sold sock before the price increased, because then they would not have had to share the benefits
of the new product with the new stockholders. Therefore, one would expect a firm with very
favorable prospects to try to avoid selling stock and rather, to raise any required new capital by
other means, including using debt beyond the normal targest capital structure.
Now, let’s consider Firm U. suppose its managers have information that new orders are off
sharply because a competitor has installed new technology which has improved its products’
quality. Firm U must upgrade its own facilities, at a high cost, just to maintain in recent sales
level. As a result, in return on investment will fall (but not as much as if it took no action, which
would lead to a 100 percent loss through bankruptcy). How should Firm U raise the needed
capital? Here the situation is just the reverse of that facing Firm F, which did not want to sell
stock so as to avoid having to share the benefits of future development. A firm with unfavorable
prospects would want to sell stock, which would mean bringing in new investors to share the
losses.
The conclusion from all this is that firms with extremely bright prospect prefer not to finance
through new stock offerings, whereas firms with poor prospects do like to finance with outside
equity. How should you, as an investor, react to this conclusion?

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