CHAPTER TWO

LEVERAGE , CAPITAL STRUCTURE AND

DIVIDEND POLICY

Discussion Points
Introduction
Capital Structure Defined
Operating Leverage
Measuring the Degree of Operating Leverage (DOL)
Meaning of Financial Leverage
Measuring the Degree of Financial Leverage (DFL)
Total Leverage
Determining the Optimum Capital Structure
I. Introduction
 Given the capital budgeting decision of a firm, it has to decide
the way in which the capital projects will be financed.
 Every time the firm makes an investment decision, it is at the
same time making a financing decision also. For example, a
decision to build a new plant or to buy a new machine implies
specific way of financing that project. Should a firm employ
equity or debt or both? What are implications of the debt
equity mix? What is an appropriate mix of debt and equity?
 …Cont’d

Capital Structure Defined

The assets of a company can be financed either by increasing
the owners’ claims or the creditors’ claims.
The owners’ claims increase when the firm raises funds by
issuing ordinary shares or by retaining the earnings; the
creditors’ claims increase by borrowing.
The various means of financing represent the financial
structure of an enterprise.
The term capital structure is used to represent the
proportionate relationship between debt and equity. Equity
includes paid-up share capital, share premium & reserves and
surplus (retained earnings).
 …Cont’d

 The financing or capital structure decision is a significant

managerial decision. It influences the shareholders return and
risk. Consequently, the market value of the share may be
affected by the capital structure decision.
 The company will have to plan its capital structure initially at
the time of its promotion. Subsequently, when funds are to
be raised to finance investments, a capital structure decision
is involved.
 …Cont’d

 The company’s policy to retain or distribute earnings affects

the owners’ claims. Shareholders’ equity position is
strengthened by retention of earnings.
 The new financing decision of the company may affect its
debt – equity mix. The debt – equity mix has implications for
the shareholders’ earnings and risk, which in turn, will affect
the cost of capital and the market value of the firm.
 …Cont’d

 The management of a company should seek answers to the

following questions while making the financing decision:
 How should the investment project be financed?
 Does the way in which the investment projects are
financed matter?
 How does financing affect the shareholders’ risk, return
and value?
 Does there exist an optimum financing mix in terms of the
maximum value to shareholders of a company?
 What factors in practice should a company consider in
designing its financing policy?
Leverage Analysis

1. Leverage in Physics
– Lifting heavy weight with small force
2. Leverage in Politics
– Mobilizing many people with few
words
3. Leverage in Finance
– changing profit significantly with slight
change in sales
7
 Types of leverage
Leverage is the portion of the fixed cost
which represent a risk to the firm. There
are two kinds of leverage
1.Operating Leverage: it is the measure of
operating risk and arise from fixed
operating costs. It is the measure of the
effect of change in sales on earning
before interest and tax

8
II. Operating Leverage
 If fixed operating costs are present in a firms cost structure,
so is operating leverage. Therefore, operating leverage arises
from the firm’s use of fixed operating costs.
 Operating leverage is the responsiveness of the firm’s EBIT to
fluctuations in sales.
 It refers to the magnification of gains and losses in EBIT by
changes that occur in sales, or
 Operating leverage refers to the potential use of fixed
operating costs to magnify the effects of changes in sales on
the firm’s EBIT.
 (Operating leverage Cont’d)

Example
To illustrate, assume that Recter Co. has fixed operating costs of
Birr 2,500, unit selling price of Birr 10, and variable operating
cost per unit of Birr 5. Now to see the impact of operating
leverage, let’s assume some changes in sales volume and see
what will happen to the firm’s EBIT as a result. Let’s assume two
changes:
Case 1: a 50% increase in sales, and
Case 2: a 50% decrease in sales.
 (Operating leverage Cont’d)

 The table below shows the resultant change in EBIT from the
two changes in sales.
Table 3.1: Illustration – Operating Leverage
Case Sales in Increase/ EBIT Increase(decr
Units Decrease in ease in EBIT
sales
Normal 1,000 - 2,500 -
I 1,500 50% 5,000 100%

 We can IIsee that in500 (50%)

Case 1, a 50% 0
increase (100%)
in sales (from 1,000
to 1,500 units) results in a 100% (from Birr 2,500 to 5,000)
increase in EBIT.
 (Operating leverage Cont’d)

 In Case 2, a 50% decrease in sales result in a 100% decrease in EBIT.

Thus, we see that the rate of change in EBIT is more than
proportional to the corresponding change in sales. That is, a 50%
change in sales is magnified in to 100% change in EBIT.
 It is the existence of fixed operating costs that magnifies the effects
of a given change in sales on the EBIT.
 The higher the percentage of fixed costs to total costs
in a firm’s cost structure, the greater the firm’s degree of operating
leverage, and then the higher the responsiveness of EBIT to a given
change in sales.
 Operating leverage is related to the firm’s business risk, which
refers to the risk inherent in the firm’s investments – the
uncertainty surrounding sales and costs.
(Operating leverage Cont’d)
 (Operating leverage Cont’d)

 The meaning of a 2.0 DOL is that from the current base sales
level, for every 1 percent change in sales within the relevant
range, there will be a 2 percent change in EBIT in the same
direction as the sales change.
 As long as DOL is greater than 1, there is an operating
leverage.
III. Meaning of Financial Leverage
 Financial leverage results from the presence of fixed-financing
costs in the firm’s capital structure.
 The fixed-cost financing sources are debt (requiring interest
payments), preferred stock (requiring the company to make
preferred dividend payments), and leases (which require
specified lease payments).
 The financing cost on these capital sources, interest,
preferred stock dividends, and lease payments must be paid
regardless of the amount of EBIT available to pay them.
 Financial leverage is the responsiveness of the firm’s earnings
per share (EPS) to changes in EBIT.
 (Financial Leverage Cont’d)

 The use of fixed-charges sources of funds,

such as debt and preference capital along with
the owners’ equity in the capital structure, is
described as financial leverage or gearing or
trading on equity.
 (Financial Leverage Cont’d)

Example:
GG Co. expects EBIT of Birr 10,000 in the current year. It has Birr
20,000 bond with a 10% coupon rate of interest and an issue of
600 shares of Birr 4 (annual dividend per share) preferred stock
outstanding. It also has 1,000 shares of common stock
outstanding. Assume 40% increase or decrease
Annual interest on the bond = Br. 20,000*0.1 = Br. 2000.
Annual dividends on preferred stock = 600 shares * Br. 4 per
share = Br. 2,400.
The table below presents the EPS corresponding to EBIT of Br.
6,000, Br. 10,000 and Br. 14,000, assuming a tax rate of 40%.
 (Financial Leverage Cont’d)

Table 3.2 Illustration – Financial Leverage

Case 1 Normal Case Case 2
EBIT Br. 6,000 Br. 10,000 Br. 14,000
Less: Interest 2,000 2,000 2,000
Net Profits before taxes 4,000 8,000 12,000
Less: Taxes (T = 0.40) 1,600 3,200 4,800
Net Profit After Taxes 2,400 4,800 7,200
Less: Preferred Stock Dividends 2400 2,400 2,400
Earnings available for Common 0 2,400 4,800
Stockholders
Earnings per Share (EPS) 0/1000 = Br. 0 2,400/1000 = 4,800/1000 =
Br. 2.40 Br. 4.80
 (Financial Leverage Cont’d)

Two situations are illustrated in the above table:

Case 1: a 40% decrease in EBIT (from Br. 10,000 to Br. 6,000)
resulted in a 100% decrease in EPS (from Birr 2.4 to Br.
0).
Case 2: a 40% increase in EBIT (from Br. 10,000 to Br. 14,000)
resulted in a 100% increase in EPS (from Br. 2.40 to Br.
4.80).
The effect of financial leverage is such that a change in the
firm’s EBIT results in a more proportionate change in the firm’s
EPS.
IV. Measuring the Degree of Financial Leverage
(Measuring Financial Cont’d)
 (Measuring Financial Cont’d)
 Unlike interest and lease payments, preferred dividend
payments are not tax deductible(the organization can’t
deduct tax for gov’t). Therefore, a Birr paid in preferred
dividends is more costly to the firm than a birr paid in interest
or lease payments.
 The effect of financial leverage is to magnify changes in EBIT
into larger changes in EPS.
(Measuring Financial Cont’d)
 (Measuring Financial Cont’d)

 For example, if a firm has a DOL of 2.25 and a DFL of

1.4, the DCL will be 2.25 times 1.4 = 3.15. This means
that for every 1 percent change in sales, EPS will
change 3.15 percent in the same direction. This
magnification is the result of both operating leverage
and financial leverage.
 V. Determining the Optimal Capital Structure

 It is generally believed that the value of the firm is maximized

when the weighted average cost of capital (WACC) is
minimized.
 The capital structure where WACC is minimum is the point of
optimal financial leverage and hence of optimal capital
structure.
 Generally, the lower firm’s WACC, the greater the difference
between the return on a project and this cost, and therefore,
the greater the owner’s return. Simply stated, minimizing the
WACC allows management to undertake a large number of
profitable projects, thereby further increasing the value of the
firm.
 (Determining the Optimal Cont’d)
EBIT – EPS Analysis
Assume that there are three possible financing mixes for Ghibe Co.
Table 3.3 Illustration EBIT – EPS Analysis
Plan A: No Debt Total Debt Br. 0
Common Equity Br. 200,000a
Total assets Br. 200,000 Total Liab. & Equity Br. 200,000

Plan B: 25% debt and 8% interest rate

Total Debt Br. 50,000

Common Stock 150,000b

Total Assets Br. 200,000 Total liab. & Equity Br. 200,000

Plan C: 40% debt and 8% interest rate

Total debt Br. 80,000

Common Equity 120,000c

Total Assets Br. 200,000 Total liab. & Equity Br. 200,000
 (Determining the Optimal Cont’d)
a
2,000 Common share outstanding
b
1,500 common shares outstanding
c
1,200 common shares outstanding

The EBIT – EPS approach to capital structure involves selecting the

capital structure that maximizes EPS over the expected range of EBIT.
Here the main emphasis is on the effects of various capital structures
on owners’ returns.
Example:
Assume that Plan B is the existing capital structure for Ghibe Co.
Furthermore, EBIT is expected to be Br. 20,000 per year for a very long
time. An investment is available for Ghibe that will cost Br. 50,000.
Acquisition of this asset is expected to raise the projected EBIT level to
Br. 30,000. The firm has two options to raise the needed cash by:
 (Determining the Optimal Cont’d)

(1) Selling 500 shares of common stock at Br. 100 each

or,
(2) Selling a new bonds that will net the firm Br. 50,000
and carry an interest rate of 8.5%.
These capital structures and corresponding EPS amounts are
summarized in the following table:
 (Determining the Optimal Cont’d)
Table 3.4 Shows Options of Capital Structure
Existing Capital Structure With New Common Stock With New Debt Financing
Financing
Long-term Br. 50,000 Long-Term Br. 50,000 Long-Term Br. 50,000
debt @ 8% debt @ 8% debt @ 8%
Common 150,000 Common 200,000 Long-Term 50,000
Stock Stock debt @ 8.5%
Common 150,000
Stock
Total L&E Br. 200,000 Total L&E Br. 250,000 Total L&E Br. 250,000
Common 1,500 Common 2,000 Common 1,500
shares shares shares
outstanding outstanding outstanding
 (Determining the Optimal Cont’d)

Table 3.5 Part B: Projected Sales

Existing With new With new debt

Capital common stock financing
Structure financing
EBIT Br. 20,000 Br. 30,000 Br. 30,000
Less: Interest Expense (4,000) (4,000) (8,250)
EBT 16,000 26,000 21,750
Less: Taxes (8,000) (13,000) (10,875)
Net Income 8,000 13,000 10,875
Less: Preferred Dividends 0 0 0
Earnings Available to 8,000 13,000 10,875
Common
EPS Br. 5.33 Br. 6.50 Br. 7.25
 (Determining the Optimal Cont’d)
 At the projected EBIT level of Br. 30,000, the EPS for the common
stock and debt alternative are Br. 6.50 and Br. 7.25, respectively.
 Both are considerably above the Br. 5.33 that would occur if the new
project were rejected and the additional financial capital were not
raised.
 Based on a criterion of selecting the financing plan that will provide
the highest EPS, the bond alternative is favored. But what if the basic
business risk to which the firm is exposed causes the EBIT level to
vary over a considerable range?
 Can we be sure the bond alternative will always have the higher EPS
associated with it? The answer of course is ‘No’. When the EBIT level
is subject to uncertainty, a graphical analysis of the proposed
financing plans can provide useful information to the financial
manager.
 (Determining the Optimal Cont’d)
Bond Plan

Common Stock Plan

9.00
8.00

6.00
EPS
4.00

2.00

1.00

0 10 20 30 40 50
EBIT (‘000 Br.)
 (Determining the Optimal Cont’d)
 The EBIT-EPS analysis graph allows the decision maker to visualize the
impact of different financing plans on EPS over a range of EBIT levels.
The relationship between EBIT and EPS is linear.
Computing the Indifference Point
 The point of intersection in the graph is called the EBIT-EPS indifference
point. It defines the EBIT level at which the EPS will be the same
regardless of the financing plan chosen by the financial manager.
 This indifference point, sometimes called the breakeven point, has
major implications for financial planning. At EBIT amounts in excess of
the EBIT indifference level, use of more debt will generate higher EPS.
At EBIT amounts below the EBIT indifference level, the financing plan
involving less leverage will generate a higher EPS.
(Determining the Optimal Cont’d)
(Determining the Optimal Cont’d)
 (Determining the Optimal Cont’d)

The Theory of Capital Structure

How should the firm go about choosing its debt/equity ratio?
Here, as always, we assume that the guiding principle is to
choose the course of action that maximizes the value of a share
of stock. This is essentially the same as maximizing the value of
the whole firm.
The important point here is, what happens to the weighted
average cost of capital (WACC) when we vary the amount of
debt financing or the debt/equity ratio.
 (Determining the Optimal Cont’d)
 A primary reason for studying the WACC is that the value of the
firm is maximized when the WACC is minimized.
 The WACC is a discount rate that is appropriate for the firm’s
overall cash flows. Since values and discount rates move in
opposite directions, minimizing the WACC will maximize the value
of the firm’s cash flows.
 Thus, we will choose the firm’s capital structure at the point
where the WACC is minimized. For this reason, we will say that
one capital structure is better than another if it results in a lower
weighted average cost of capital.
 Further, we say that a particular debt/equity ratio represents the
optimal capital structure if it results in the lowest possible WACC.
This is sometimes called the firm’s target capital structure as well.
 WACC
 WACC is the traditional view of capital
structure, risk and return.

D  E 
WACC  rA    rD     rE 
V  V 
 WACC
Example - A firm has $2 mil of debt and 100,000
of outstanding shares at $30 each. If they can
borrow at 8% and the stockholders require
15% return what is the firm’s WACC?

D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
 WACC
Example - A firm has $2 mil of debt and 100,000 of outstanding
shares at $30 each. If they can borrow at 8% and the
stockholders require 15% return what is the firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million

D  E 
WACC    rD     rE 
V  V 
2  3 
   .08     .15 
5  5 
 .122 or 12.2%
 Capital structure theories
• Is developed by Franco Modigliani and
Merton miller
• Also called M&M theories
• Theories were developed under world
With no taxes and
With taxes
 Capital structure theories

• Consider two firms which are identical except

for their financial structures. The first (Firm U)
is unlevered: i.e financed by equity only. The
other (Firm L) is levered: i.e financed partly by
equity, and partly by debt. The M–M theorem
states that the value of the two firms is same.
 Capital structure theories
Under NO taxes
• Preposition I, VU=VL( value of unlevered firm
equals with value of levered firm
• PrepositionII,VE(levered)=rE(unlevered)+D/
E(rE(unlevered)-rD
• Where rE= cost of equity
rD= cost of debt
D/E= debt to equity ratio
 Capital structure theories
• With taxes
P1; VL= VU+TCD where VL= Value of levered firm
VU=Value of Unlevered firm
TCD=Tax rate X Value of debt(D)
PII;VL= ro+D/E(ro-rD)(1-Tc)
Ro=cost of equity capital (unlevered firm)
rD= rate of return on borrowing
Tc= Tax rate
 Capital structure theories
• Assumptions
• Taxes are on earning after interest
• No transaction cost exist
• Individuals or organizations borrow at the
same rate
 Dividend and dividend policy
Key Concepts and Skills

• Understand dividend types and how they are

paid
• Understand the issues surrounding dividend
policy decisions
• Understand the difference between cash and
stock dividends
17-47
 What is “dividend policy”?

• It’s the decision to pay out earnings versus

retaining and reinvesting them. Includes
these elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
Do investors prefer high or low payouts?
There are three theories:

• Dividends are irrelevant: Investors don’t

care about payout.
• Bird in the hand: Investors prefer a high
payout.
• Tax preference: Investors prefer a low
payout, hence growth.
 Cash Dividends
• Regular cash dividend – cash payments
made directly to stockholders, usually
each quarter
• Extra or special cash dividend –
indication that the “extra” amount may
not be repeated in the future
• Liquidating dividend – some or all of the
business has been sold

17-50
 Dividend Payment
• Declaration Date – Board declares the dividend, and it
becomes a liability of the firm
• Ex-dividend Date
– Occurs two business days before date of record
– If you buy stock on or after this date, you will not receive
the dividend
– Stock price generally drops by about the amount of the
dividend
• Date of Record – Holders of record are determined,
and they will receive the dividend payment
• Date of Payment – checks are mailed

17-51
 Does Dividend Policy Matter?
• Dividends matter – the value of the stock is based on
the present value of expected future dividends
• Dividend policy may not matter
– Dividend policy is the decision to pay dividends versus
retaining funds to reinvest in the firm
– In theory, if the firm reinvests capital now, it will grow and
can pay higher dividends in the future

17-52
Illustration of Irrelevance
• Consider a firm that can either pay out dividends of
$10,000 per year for each of the next two years or can
pay $9,000 this year, reinvest the other $1,000 into
the firm and then pay $11,120 next year. Investors
require a 12% return.
– Market Value with constant dividend = $16,900.51
– Market Value with reinvestment = $16,900.51
• If the company will earn the required return, then it
doesn’t matter when it pays the dividends

17-53
 Low Payout Please
• Why might a low payout be desirable?
– Individuals in upper income tax brackets might
prefer lower dividend payouts, given the immediate
tax liability, in favor of higher capital gains with the
deferred tax liability
– Flotation costs – low payouts can decrease the
amount of capital that needs to be raised, thereby
lowering flotation costs
– Dividend restrictions – debt contracts might limit
the percentage of income that can be paid out as
dividends

17-54
 High Payout Please
• Why might a high payout be desirable?
– Desire for current income
• Individuals that need current income, i.e., retirees
• Groups that are prohibited from spending principal
(trusts and endowments)
– Uncertainty resolution – no guarantee that the
higher future dividends will materialize
– Taxes
• Dividend exclusion for corporations
• Tax-exempt investors don’t have to worry about
differential treatment between dividends and
capital gains

17-55
 Dividends and Signals
• Asymmetric information – managers have more
information about the health of the company
than investors
• Changes in dividends convey information
– Dividend increases
• Expectation of higher future dividends, increasing present
value
• Signal of a healthy, growing firm
– Dividend decreases
• Expectation of lower dividends indefinitely; decreasing
present value
• Signal of a firm that is having financial difficulties

17-56
 Stock Dividends
• Pay additional shares of stock instead of cash
• Increases the number of outstanding shares
• Small stock dividend
– Less than 20 to 25%
– If you own 100 shares and the company
declared a 10% stock dividend, you would
receive an additional 10 shares
• Large stock dividend – more than 20 to 25%

17-57
 Stock Splits
• Stock splits – essentially the same as a stock
dividend except expressed as a ratio
• Stock price is reduced when the stock splits
• Common explanation for split is to return price
to a “more desirable trading range”

17-58