Capital Structure and Leverage

• Business vs. financial risk

• Optimal capital structure
• Operating leverage
• Capital structure theory
• The use of debt increases the risk borne by
shareholders
• However, using debt leads to higher
expected rates of return by shareholders.
• The firm’s optimal capital structure is the
one that balances the influence of risk and
return and thus maximizes the firm’s stock
price.
 Four factors influence the firm’s capital
structure decision
1. Business risk
 Uncertainty about future operating income
(EBIT) if it used on debt
 The greater the firm’s business risk, the
lower its optimal debt ratio

2. The firm’s tax position

A major reason for using debt is that interest is
deductible, which lowers the effective cost
of debt.
3. Financial flexibility
This is the firm’s ability to raise capital with
reasonable terms under adverse conditions.
The greater the probable future need for capital,
and the worse the consequences of a capital
shortage, the stronger the balance sheet should
be.
4. The conservatism or aggressiveness of
management
Firms with aggressive managers are more inclined
to use debt in an effort to boost profits.
 Business risk is affected primarily by:
• Uncertainty about demand (sales).
• Uncertainty about output prices.
• Uncertainty about costs.
• Ability to adjust output prices for changes in
input prices.
• Operating leverage (the extent to which costs
are fixed).
 What is operating leverage, and how does it
affect a firm’s business risk?
• Operating leverage is the use of fixed costs rather
than variable costs.
• If most costs are fixed, hence do not decline when
demand falls, then the firm has high operating
leverage.
• A high degree of operating leverage implies that a
relatively small change in sales results in a large
change in ROE.
• Operating breakpoint
The amount quantity at which Sales = Costs,
hence when EBIT = 0.
Sales = Costs
P*Q = V*Q + F
Where P is average sales price per unit of output,
Q is units of output, V is variable cost per unit

EBIT = PQ – VQ- F = 0
Breakeven Q = F/(P-V)
EX)
Plan A :F = $40,000, P =$4, V=$3, Assets = $ 400,000
Plan B: F = $120,000, P =$4, V=$2 Assets = $ 400,000

BE for A = 40,000 units

BE for B = 60,000 units
• More operating leverage leads to more
business risk, for then a small sales decline
causes a big profit decline.

$ Rev. $ Rev.
TC } Profit
TC
FC
FC

QBE Sales QBE Sales

• Plan B has a higher expected EBIT (and
hence ROE), but this plan also entails a
much higher probability of losses.
• In general, holding other factors constant,
the higher the degree of operating leverage,
the greater the firm’s business risk.
Probability Low operating leverage

High operating leverage

EBITA EBITB
• Degree of operating leverage (DOL)
The degree of operating leverage is defined as the
percentage change in operating income (EBIT)
that results from a given percentage change in
sales.

DOL = % change in EBIT / % change in sales

Another way to estimate DOL is:

DOLQ = Q (P-V) / [Q (P-V) – F] based on output

units Q

DOLS = S -VC / [S -VC – F] based on dollar sales

Assume the quantity produced in the previous
example is 100,000 units.
For Plan A:
DOLQ = Q (P-V) / [Q (P-V) – F]
= 100,000 (4-3) / [100,000 (4-3) – 40,000]
= 1.67
For Plan B:
DOLQ = 100,000 (4-2) /[100,000 (4-2)– 120,000]
= 2.5
• The results suggest that if Plan A has 1%
increase in sales, it’s EBIT will increase by
1.67%, while for Project B the increase in
EBIT will be 2.5%.
 What is financial leverage?
Financial risk?
• Financial leverage is the extent to which fixed-
income securities (debt and preferred stock) are used
in a firm’s capital structure
• Financial risk is an increase in stockholder’s risk
over and above the firm’s basic business risk,
resulting from the use of financial leverage.
• The use of debt (financial leverage) concentrates the
firm’s business risk on its stockholders. This
concentration occurs because debtholders who
receive fixed interest payments bear none of the
business risk.
Business Risk vs. Financial Risk

• Business risk depends on business factors

such as competition, product liability, and
operating leverage.
• Financial risk depends only on the types of
securities issued: More debt, more financial
risk.
 Consider 2 Hypothetical Firms

Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Both firms have the same operating
leverage, business risk, and probability
distribution of EBIT. Differ only with
respect to use of debt (capital structure).
 Firm U: Unleveraged

Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
 Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
• Basic Earning Power (BEP)
BEP = EBIT / Total Assets
This ratio shows the raw earning power of the
firm’s assets, before the influence of taxes
and leverage.
It is useful for comparing firms with different
tax situations and different degrees of
financial leverage.
• Times Interest Earned (TIE) ratio =
EBIT / Interest charges

A measure of the firm’s ability to meet its

annual interest payments.
• Coefficient of variation
= standard deviation / expected return
CV shows standard measure of the risk per
unit of return, and it provides a more
meaningful basis for comparison when the
expected returns on two alternatives are not
the same.
Firm U Bad Avg. Good
BEP* 10.0% 15.0% 20.0%
ROE 6.0% 9.0% 12.0%

8
TIE

Firm L Bad Avg. Good

BEP* 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
TIE 1.67 2.5 3.3
*BEP same for Firms U and L.
Expected Values:
U L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%

8
E(TIE) 2.5

Risk Measures:
sROE 2.12% 4.24%
CVROE 0.24 0.39
For leverage to raise expected ROE,
must have BEP > kd.
Why? If kd > BEP, then the interest
expense will be higher than the
operating income produced by
debt-financed assets, so leverage
will depress income.
 Conclusions
• Basic earning power = BEP = EBIT/Total
assets is unaffected by financial leverage.
• L has higher expected ROE because BEP > kd.
• L has much wider ROE (and EPS) swings
because of fixed interest charges. Its higher
expected return is accompanied by higher risk.
• Degree of financial leverage (DFL)
Financial leverage takes over where operating
leverage leaves off, magnifying the effect of
changes in sales on EPS.

For this reason, operating leverage is sometimes

referred to as first-stage leverage and financial
leverage as second-stage leverage.
• The degree of financial degree is defined as the
percentage change in EPS that results from a
given percentage change in EBIT.
DFL = % change in EPS / % change in EBIT.
or
= EBIT / [EBIT – I]
• Jayco has $2 million in sales, variable costs
of 70% of sales, fixed costs of $100,000 and
annual interest expense of $50,000. If
Jayco’s EBIT increases by 10% how much
% will its EPS increase?
Combining operating and financial leverage

So far, we know that:

The greater the use of fixed operating costs as
measured by DOL, the more sensitive EBIT
will be to change in sales
The greater the use of debt as measured by
DFL, the more sensitive EPS will be to
changes in EBIT
If a firm uses a considerable amount of both
operating leverage and financial leverage
then a slight change in sales will lead to
wide fluctuations in EPS.

The degree of total leverage, which combines

the degree of operating leverage and
financial leverage, shows how a given
change in sales will affect EPS.
• DTL = DOL* DFL
= (% EBIT/ % sales) * (% EPS/ % EBIT)
= % EPS/ % sales
DTL = [Q (P-C)] / [Q(P-V)-F-I]
DTL = [S-VC] / [ S-VC-F-I ]

Ex) How much will Jayco’s EPS increase if the

company’s sales increase by 10%?