LEVERAGE AND

CAPITAL
STRUCTURE
 Leverage
It is an investment strategy of using
borrowed money—specifically, the
use of various financial instruments
or borrowed capital—to increase
the potential return of an
investment.
 Types of Leverage
 
Operating leverage
-It is a cost-accounting formula that
measures the degree to which a firm or
project can increase operating income
by increasing revenue.

Degree of operating leverage (DOL) =

Contribution / EBIT
Financial leverage
-It is a metric that shows how much a
company uses debt to finance its
operations.

Leverage = total company debt

/shareholder's equity

 
Combined leverage
-It is a leverage which refers to high
profits fue to fixed cost.
Degree of combined leverage = contribution
/EBIT
 
Contribution = Sales - Variable cost
EBIT= Contribution- fixed cost - Interest
DCL = Contribution / EBIT
Working capital leverage
-refers to the impact of level of
working capital on company’s
profitability.

WCL= Current Asset/ Total

Asset+ Current asset.
 Financial leverage
-also known as leverage or
trading on equity, refers to
the use of debt to acquire
additional assets.
 Capital Structure
-particular combination of
debt and equity used by a
company to finance its overall
operations and growth.
 The effect of financial leverage

 an increase in the value of the assets will

result in a larger gain on the owner's cash,
when the loan interest rate is less than the
rate of increase in the asset's value.

 a decrease in the value of the assets will

result in a larger loss on the owner's cash
 EPS vs. EBIT

-The EBIT-EPS approach to capital

structure is a tool businesses use to
determine the best ratio of debt
and equity that should be used to
finance the business' assets and
operations.
 Corporate borrowing
-borrowing by businesses rather than by
individuals

Homemade leverage
-It is the use of personal borrowing of
investors to change the amount of financial
leverage of the firm. Investors can use
homemade leverage to change an
unleveraged firm into a leveraged firm.
Financial Leverage Computation:

Leverage = total company debt/shareholder's

equity
 Financial Risk

-is any of various types of risk

associated with financing,
including financial transactions
that include company loans in risk
of default.
 Types of financial risk

Credit risk -That a customer or borrower

will default on a receivable or loan.
 
Equity risk - That losses will be incurred
on equity holdings when the shares of
stock in a business exhibit rapid price
changes.
 
 
Operational risk – It means that the risk
of a company or individual has to face
due their own operation and decisions
made for the investment.
 Business Risk

-It is the exposure a company

or organization has to factor(s)
that will lower its profits or
lead it to fail.
Types of Business Risk

Physical Risk
Physical damage will result in repair or replacement
costs and can also lead to legal costs if you are
found liable in some way.

Technology Risk
These risks can range from anything as basic as a
power outage through to hardware and software
failure, malware and cyber-attacks.
Human Risk
-  Their behavior in the work place can create
risk if they are incompetent or non-compliant,
while their behavior outside the workplace can
also impact, for example, if they are misusing
drugs or alcohol.
 
Compliance Risk
- The possibility of failing to adhere to these
rules and guidelines equates to compliance risk
and of course can lead to fines, prosecution
and reputational damage.
 Capital Structure and the Cost of
Equity Capital

We have seen that there is nothing

special about corporate borrowing
because investors can borrow or lend
on their own. As a result, whichever
capital structure company chooses,
the stock price will be the same.
Capital structure is thus irrelevant.
 Financial Distress and
Bankruptcy Cost
 
•Financial distress - is a condition in
which a company or individual cannot
generate revenue or income because it
is unable to meet or cannot pay its
financial obligations.
 Cost of financial distress
- added cost of debt financing.

Bankruptcy
- the legal term used to describe
the process needed to help repay
debts and other obligations.
• Companies use debt and equity achieve
an optimal capital structure and finance
their operations.

•Those that finance themselves with debt

are seen as more valuable because they can
use interest to decrease their tax liabilities.

•There are tax advantages to using debt to

manage their operations.
 
 Interest Tax Shield

- refers to the reduced income

taxes brought about by deductions
to taxable income from a
company’s interest expense.
But as they decide to take on
•

more debt, their weighted

average cost of capital
( WACC) increases.
 Bankruptcy Cost

- cost incurred during the process

of bankruptcy.

•Bankruptcy costs arise when

there is a greater likelihood a
company will default on its financial
obligations.
WEIGHTED AVERAGE COST OF
CAPITAL
Re = total cost of equity
Rd = total cost of debt
E = market value total equity
D = market value of total debt
V = total market value of the
company’s combined debt and
equity or E + D
E/V = equity portion of total
financing
D/V = debt portion of total
financing
Tc = income tax rate
THANK YOU!!!