Capital Structure and

Leverage
* Capital Structure and Leverage
Companies can finance with either debt or equity.
Is one better than the other?
If not then, What is the optimal mix?
 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
What is Leverage?
 What is Leverage?
1. The use of various financial instruments or borrowed
capital, to increase the potential return of an investment. 

2. The amount of debt used to finance a firm's assets. A firm

with significantly more debt than equity is considered to be
highly leveraged.

3.The degree/extent to which an investor or business is

utilizing borrowed money.
*Target Capital Structure
It is the mix of debt, preferred stock and common equity
with which the firm plans to raise capital.
Using more debt raises the risk borne by stockholders-
because any losses (if occur) will be shared by S.H.
However, using more debt generally leads to a higher
expected rate of return on equity- because int. is tax
deductible

Higher risk tends to lower a stock’s price, but a higher

expected rate of return raises it. (trade off)
Therefore the optimal capital structure must strike a balance
between risk and return so as to maximise the firm’s stock
price and simultaneously minimise the cost of capital.
*Primary Factors that influence C.S
T.C.S may change over time as conditions / factors
change.

Business Risk
The firm’s tax position
Financial flexibility
Managerial conservatism or aggressiveness
Business Risk
Uncertainty about future operating income (EBIT),
i.e., how well can we predict operating income?
ROIC=NOPAT/Capital
= Net income to common stock holders+ After tax
interest payments / capital
ROIC (zero debt)= ROE=Net income to common stock
holders/common equity

ROIC= return on invested Capital

NOPAT=Net Operating Profit after taxes
DISCUSSION QUESTION: 
BUSINESS RISK VARIES FROM INDUSTRY TO INDUSTRY AND FIRMS TO FIRMS. WHY?
 

FACTORS CONTRIBUTING TO BUSINESS RISK:

 
DEMAND VARIABILITY:
 
THE STABLE THE DEMAND FOR A FIRM’S PRODUCTS, OTHER THINGS BEING
CONSTANT THE LOWER THE BUSINESS RISK
 
SALES PRICE VARIABILITY:
 
PRODUCTS THAT ARE SOLD IN HIGH VOLATILE MARKETS ARE EXPOSED TO
MORE BUSINESS RISK COMPARE TO STABLE FIRMS.

Volatile markets are ones where the price moves vigorously and unpredictably.
 
INPUT COST VARIABILITY:
 
INPUT COSTS THAT ARE HIGHLY UNCERTAIN HAVE HIGHER DEGREE OF
BUSINESS RISK
ABILITY TO ADJUST OUTPUT PRICES FOR CHANGES IN INPUT PRICES:
 
THE GREATER THE ABILITY TO ADJUST OUTPUT PRICES WHEN INPUT COST
RISES
 
FOREIGN RISK EXPOSURE:
 
IF EARNINGS ARE COMING FROM OVERSEAS THEN HIGHER THE BUSINESS
RISK
 
THE EXTEND TO WHICH COSTS ARE FIXED (OPERATING LEVERAGE):
 
IF COSTS ARE FIXED AND DEMAND FALLS, THEN BUSINESS RISK INCREASES.
IF A HIGH % OF TOTAL COST IS FIXED THEN FIRM IS SAID TO HAVE A HIGH
DEGREE OF OPERATING LEVERAGE.
OPERATING LEVERAGE
THE EXTENT TO WHICH FIXED COSTS ARE USED IN A FIRM’S
OPERATIONS

OTHER THINGS HELD CONSTANT , THE HIGHER THE FIRM’S

FIXED COSTS , THE HIGHER WOULD BE ITS BUSINESS RISK.

IF MOST COSTS ARE FIXED, HENCE DO NOT DECLINE WHEN

DEMAND FALLS, THEN THE FIRM HAS HIGH OPERATING
LEVERAGE.

HIGH FIXED COSTS =HIGHER OPERATING LEVERAGE = high

business risk
Effect of operating leverage
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
BREAKEVEN POINT
THE VOLUME OF SALES AT WHICH THE TOTAL
COSTS EQUAL TOTAL REVENUES, CAUSING
OPERATING PROFITS (OR EBIT) TP EQUAL ZERO

SALES=COSTS

PQ=V+F

Q(BE)=F/P-V
OPERATING LEVERAGE
HOW DOES OPERATING LEVERAGE AFFECT A
PROJECT’S OR FIRM’S EXPECTED RATE OF
RETURN , AND THE RISKINESS OF THE
PROJECT OF THE FIRM?
OPERATING LEVERAGE
OTHER THINGS HELD CONSTANT, USING
MORE OPERATING LEVERAGE RAISES THE
EXPECTED RATE OF RETURN , BUT ALSO
INCREASES THE RISKINESS OF THAT RETURN

HIGH FIXED COSTS ARE GENERALLY

ASSOCIATED WITH HIGHLY AUTOMATED ,
CAPITAL INTENSIVE FIRMS AND INDUSTRIES.
 PLAN A PLAN B
PRICE $2.00 $2.00
VARIABLE COST $1.50 $1.00
FIXED COST $20000 $60000
ASSETS $200000 $200000
TAX RATE 40% 40%

OPERATING COST=VERIABLE COST+FIXED COST

TAX RATE = 40%, SO NI= EBIT (1-TAX RATE) = EBIT (0.6)
ROE=NI/EQUITY. THE FIR HAS NO DEBTS SO,
ASSETS=EQUITY=$200000

DEMAN PRO UNITS DOLLAR OPERATI EBIT NI ROE OPERATING EBIT NI ROE
D (1) B (2) SOLD (3) SALES $ NG COST $ (6) $ (7) % COST $ (10) $ (11) %
(4) $ (5) (8) $ (9) (12)
TERRIBL 0 0
E 0.05
POOR 0.2 40000 80000

NORMA 0.5 100000 200000

L
GOOD 0.2 160000 320000

WONDE 0.05 200000 400000

RFUL

EXPECTE
D
VALUE
STAND.
DEV
Financial Risk
It is the additional risk that is placed on the common
stock holder as a result of the decision to finance with
debt.
FINANCIAL LEVERAGE:

THE EXTENT TO WHICH FIXED INCOME SECURITIES (DEBT AND

PREFERRED STOCK)ARE USED IN A FIRM’S CAPITAL STRUCTURE

WHY IS DEBT FINANCING RISKY:

 
AS DEBT IS INTRODUCED IN THE COMPANY, ITS EPS AND RISK
CHANGES AND BOTH AFFECT THE COMPANY’S STOCK PRICE.
EXAMPLE: *
 
EBIT = 100,000
TAX RATE = 40%
EQUITY = 200,000
SHARES OUTSTANDING = 10,000
 
CASE#1: WHEN THERE IS NO DEBT FINANCING
 
 EBIT=
- INTEREST PAYMENT =
 EBT=
-TAX =
 NI= $60,000
 
ROE = NI / EQUITY =60,000/200,000 =30%

 
EPS = NI / # OF SHARES OUTSTANDING = 60,000/10,000=$6
EPS=(SALES-FIXED COST-VARIABLE COST-INT)(1-TAX RATE)/SHARE
OUTSTANDING
EPS= (EBIT-INT)(1-TAX RATE)/SHARE OUTSTANDING)
CASE #2: WHEN DEBT FINANCING IS INTRODUCED
 
EBIT = 100,000
TAX RATE = 40%
DEBT = 100,000
EQUITY = 100,000
SHARES OUTSTANDING = 5,000
INTEREST RATE = 12%

NI= $52,800
 
ROE= 52.8%
 
EPS= $10.56
 FINDINGS
FINANCING WITH DEBT INCREASES THE EXPECTED
EPS BUT IT ALSO INCREASES THE RISKINESS OF THE
INVESTMENT TO THE OWNERS AS INTEREST CHARGE
INCREASES.

RISK IS MEASURED BY STANDARD DEVIATION AND

COEFFICIENT OF VARIATION

 FINANCIAL LEVERAGE RAISES THE EXPECTED ROE

(up to certain level).
RELATIOSHIP AMONG E(EPS), RISK AND
FINANCIAL LEVERAGE
Equity/ Assets DEBT/ASSET EXPECTED EPS S.D of EPS
RATIO
100% 0% $2.40 $2.96

90 10 2.56 3.29

80 20 2.75 3.70

70 30 2.97 4.23

60 40 3.20 4.94

50 50 3.36 5.93

40 60 3.30 7.41
*Optimal Capital Structure
OPTIMAL CAPITAL STRUCTURE IS THE ONE,
WHICH MAXIMIZES THE COMPANY’S STOCK
PRICE .
Trades off higher ROE / EPS/ share price/ against
higher risk.
 The tax-related benefits of leverage are exactly offset
by the debt’s risk-related costs.
Given:
 
KRF = 6%
KM = 10%
K = REQUIRED RATE OF RETURN = K RF + Β (KM - KRF )
COMPANY PAYS ALL ITS EARNINGS AS DIVIDEND SO EPS =
DPS
 EPS VS DPS
 EPS = DPS (if all earnings are distributed among SH)
 EPS > DPS (if some earnings are distributed among SH)
 DPS can never be greater than EPS

 G= ROE * RETENTION RATE = 12% *0 = 0

 EBIT=
 - INTEREST PAYMENT =
 EBT=
 -TAX =
 NI= $60,000
 DIV = 40,000
 R.E = 20,000

 DPS=40,000/10,000 = $4
 EPS= 60,000/10,000=$6

 EBIT=
 - INTEREST PAYMENT =
 EBT=
 -TAX =
 NI= $60,000
 DIV = 60,000
 R.E = O

 DPS=60,000/10,000 = $6
 EPS=60,000/10,000 = $6
 What effect does increasing debt have on
the cost of equity for the firm?
Wd-> Kd
We-> Ke -> Ke=rf+(rm-rf )b
Wd -> Kd as well as Ke or Ke=rf+(rm-rf )b =????

If the level of debt increases, the riskiness of the firm increases.
We have already observed the increase in the cost of debt.
However, the riskiness of the firm’s equity also increases, resulting in a
higher ks.

The reason that the risk of equity increases as debt is added to the capital
structure is because debt magnifies the variability of the equity return.
The Hamada Equation
Because the increased use of debt causes both the
costs of debt and equity to increase, we need to
estimate the new cost of equity.
The Hamada equation attempts to quantify the
increased cost of equity due to financial leverage.
Uses the unlevered beta of a firm, which
represents the business risk of a firm as if it had no
debt.
The Hamada Equation
βL = βU[ 1 + (1 - T) (D/E)]

βU= unlevered beta i.e. risk when debt is zero or

it has only business risk

βL= levered beta i.e. risk with the presence of

debt (both risks are present business risk
and financial risk)
Stock Price, with zero growth
D1 EPS DPS
P0   
ks - g ks ks

If all earnings are paid out as dividends,

E(g) = 0.
EPS = DPS
To find the expected stock price (P0), we
must find the appropriate ks at each of the
debt levels discussed.
Example
Equity Debt Kd Expecte Estimat Ke=rf+ Estimat P/E WACC
ratio
Ratio d EPS = ed β (rm-rf)b ed Price ratio=
DPS (P0) = P0 / EPS
DPS / Ke

100% 0% - $2.4 1.5 12% 20 8.33 12

90 10 8% 2.56 1.55 12.2 20.98 8.2 11.46

80 20 8.3 2.75 1.65 12.6 21.83 7.94 11.08

70 30 9 2.97 1.8 13.2 22.5 7.58 10.86

60 40 10 3.2 2 14 22.86 7.14 10.8

50 50 12 3.36 2.3 15.2 22.11 6.58 11.2

40 60 15 3.30 2.7 16.8 19.64 5.95 12.12

The example shows that we can push up E(EPS) by using
more debt, but the risk resulting from increased leverage
more than offsets the benefit of higher E(EPS).
 This is not it!
INDUSTRY AVERAGE DEBT RATIO – HERD BEHAVIOR

Discussion with- SEC, RATING AGENCIES

LENDER’S ATTITUDE
Why do the bond rating and cost of debt depend
upon the amount borrowed?
As the firm borrows more money, the firm
increases its financial risk causing the firm’s
bond rating to decrease, and its cost of debt to
increase.
What makes companies to limit Debt Financing:
 
BUSINESS RISK INCREASES
 
FINANCIAL RISK INCREASES THAT CAUSES EPS
AND SHARE PRICE TO FALL.
 
BANKRUPTCY COST IS ATTACHED WITH DEBT
FINANCING.
LLR
LENDER OF THE LAST RESORT
IT MAY CREATE MORAL HAZARDS

1) BAIL OUT (STATE)

2) BAIL-IN (STAKE-HOLDERS)
 EFFECTS OF BANKRUPTCY COSTS
BANKRUPTCY OFTEN FORCES FIRMS TO LIQUIDATE OR
SELL ASSETS FOR LESS THAN THEY WOULD BE WORTH
OF THE FIRM WERE TO CONTINUE OPERATING

THREAT OF BANKRUPTCY BRINGS ABOUT PROBLEMS

AS WELL.E.G SUPPLIERS REFUSE TO GRANT CREDIT ,
LENDERS DEMAND HIGHER RATE OF INTERES ETC

BANKRUPTCY PROBLEMS ARE GOING TO ARISE WHEN

THERE IS MORE DEBT IN THE CAPITAL STRUCTURE
BANKRUPTCY COSTS HAVE TWO COMPONENTS:

TRADE OFF THEORY:

FIRMS NEED TO TRADE OFF BETWEEN BENEFITS
OF DEBT FINANCING AND HIGH INTEREST RATES
AND BANKRUPTCY COSTS.
 
SIGNALING THEORY:
1.DECIDING OPTIMAL LEVEL OF DEBT DEPENDS ON
THE TYPE OF PROJECT, WHICH THE COMPANY
TAKES UPON.
2.COMPANIES START PROJECTS TO INTRODUCE
SOMETHING NEW IN THE MARKET, WHICH HAS THE
DEMAND.
3.AS A RESULT OF THIS COMPANIES REVENUE WILL
INCREASE AND STOCK HOLDERS WILL BE BENEFITED.
4.A FIRM WITH VERY FAVORABLE PROSPECTS SHOULD
TRY TO AVOID SELLING STOCK AND SHOULD RAISE
MONEY BY ISSUING DEBT.
5.SOMETIMES COMPANIES HAVE TO START A PROJECT
TO INTRODUCE SOMETHING IN ORDER TO PROTECT
THEIR MARKET SHARE.
6.FOR SUCH PROJECTS THERE CAN BE VARIATION IN
REVENUES.
7.FOR SUCH PROJECTS COMPANIES SHOULD TRY TO
LIMIT DEBT FINANCING AND SHOULD RAISE THE
MONEY BY ISSUING TOCK.
Times Interest Earned Ratio = (net income +
interest) / interest.

The times interest earned ratio indicates the extent of

which earnings are available to meet interest payments.

A lower times interest earned ratio means less

earnings are available to meet interest payments and that
the business is more vulnerable to increases in interest
rates. 
Leverage[Firm i] = a + , B1 Tangible Assetsi + B2
Market to Book Ratios+ B3 Log Salesi + B4 Return on
Assets + si
 Three types of CS Theories
Trade off theory-Specifically, according to the tradeoff theory,
the firm value can be maximized by achieving the target capital
structure which minimizes taxes and agency costs.
Pecking Order Theory- Based on the pecking order theory,
asymmetric information, higher costs and taxes are responsible
for the popularity of debt, but the internal fund/retained
earnings should be preferred to any external financing for the
reason of efficient control.
Modigliani-Miller Irrelevance Theory (1958): Based on the
assumptions of perfect market, absence of personal taxes and
independent financial activities, the MM theory theory
indicates that the decision of capital structure is irrelevant to
firm value. However, in reality such assumptions are untenable.
Modigliani–Miller Theory (1958)
The Modigliani–Miller theorem (of Franco Modigliani,
Merton Miller) forms the basis for modern thinking on
capital structure. The basic theorem states that, under a
certain market price process, in the absence of taxes,
bankruptcy costs, agency costs, and asymmetric
information, and in an efficient market, the value of a firm
is unaffected by how that firm is financed. It does not
matter if the firm's capital is raised by issuing stock or
selling debt. It does not matter what the firm's dividend
policy is. Therefore, the Modigliani–Miller theorem is also
often called the capital structure irrelevance principle
 Assumptions of Perfect Market
(a) There are no taxes
(b) Managers have stockholder interests at hear and do
what’s best for stockholders. (no conflict of interest)
(c) No firm ever goes bankrupt
(d) Equity investors are honest with lenders; there is no
subterfuge or attempt to find loopholes in loan
agreements
(e) Firms know their future financing needs with certainty
f) No inflation
g) No brokerage cost
h) No transaction cost
Mechanics of Cost of Capital Estimation
1. Estimate the Cost of Equity at different levels of debt:
Equity will become riskier -> Beta will increase -> Cost of
Equity will increase.
Estimation will use levered beta calculation
2. Estimate the Cost of Debt at different levels of debt:
Default risk will go up and bond ratings will go down as debt
goes up -> Cost of Debt will increase.
To estimating bond ratings, we will use the interest coverage
ratio (EBIT/Interest expense)
3. Estimate the Cost of Capital at different levels of debt
4. Calculate the effect on Firm Value and Stock Price.
The Effect of Debt on the Cost of Equity
While there are different methods to compute a
company’s cost of equity, it is essentially the amount of
return a company needs to provide on its shares,
through dividends and appreciation, which will
compel investors to purchase them and thus fund the
company. It can also be viewed as a measure of the
company’s risk, since investors will demand a higher
payoff from shares of a risky company in return for
exposing themselves to higher risk. As a company’s
increased debt generally leads to increased risk, the
effect of debt is to raise a company’s cost of equity.