Capital

Structure

Capital Structure
Capital structure : The combination of debt
and equity used to finance a firm.
Target capital structure : The mix of debt,
preferred stock and common equity with
which the firm plans to finance its
investments.
Optimal Capital Structure : Optimal capital
structure is the one that strikes a balance
between risk & return to achieve ultimate
goal of maximizing the price of the stock.

Factors influence the capital structure

decisions
Four primary factors influence the capital
structure decisions :
First is the firms Business Risk, or the
riskiness that would be inherent in the firms
operations if it is used no debt. The greater
the firms business risk, the lower the amount
of debt that that is optimal.
The second key factor is the firms Tax
position. A major reason for using debt is that
interest is tax deductible, which lowers the
effective cost of debt.

Factors influence the capital structure

decisions
The third important consideration is Financial
Flexibility or the ability to raise capital on
reasonable terms under adverse conditions.
The forth debt-determining factor has to do
with managerial attitude (conservatism or
aggressiveness) with regard to borrowing .
Some managers are more aggressive than
others; hence some firms are more inclined
to use debt in an effort to boost profits. This
factor affects the target capital structure.

Business & Financial Risk

Business risk
B.R is defined as the uncertainty inherent in
projections
of future returns, either on assets
(ROA) or on equity (ROE) , if the firm uses no debt
or debt-like financing (i.e. preferred stock) it is the
risk associated with firms operations.
Financial risk
The portion of stockholders risk , over and above
basic business risk, resulting from the manner in
which the firm is financed is called Financial risk.
Financial risk results from using financial leverage,
which exists when a firm uses fixed income
securities, such as debt and preferred stock , to raise
capital.

Degree of Leverage
Degree of Operating Leverage (DOL)
DOL is defined as the percentage change in
operating income (EBIT) associated with a given
percentage change in sales. DOL is concerned with
the upper portion of the Income Statement.
DOL for a particular level of production and sales,
Q, can be computed using the following equation :
DOL Q = Q ( PV )____
Q(PV)F
DOL , based on dollar sales rather than units, can be
computed using the following equation :
DOL S = S VC___ = Gross Profit
S VC F
EBIT

Degree of Leverage
Degree of Financial Leverage (DFL)
DFL is defined as the percentage change in
earnings available to common stockholders
associated with a given percentage in earnings
before interest and taxes.
DFL is concerned with the lower part of the
Income Statement .

DFL indicates about the proportion of fixed

financial obligation exists in the firms operation.
DFL is calculated as follows :
DFL = Percentage change in EPS
=
Percentage change in EBIT

EBIT___
EBIT I

Degree of Leverage
Degree of Total Leverage (DTL)
DTL is defined as the percentage change in EPS
that results from a given percentage change in
sales.
DTL shows the effects of both operating leverage
and financial leverage.

The three equivalent equations for DTL :

1. DTL = ( DOL) X ( DFL )

2. DTL =

Q (P V )__
Q (P-V) F- I
3. DTL = ___S VC___ =
Gross Profit
S VC F- I
EBIT - I

Degree of Leverage

NOTE :

I
VC
F
S

= Interest
= Variable Cost
= Fixed Cost
= Sales

 Capital Structure

MATH

(Effect of debt on the EPS)

Given the following information, calculate (i) Earnings

Per Share (EPS) and (ii) Expected Earnings Per Share (iii)
Degree of Operating Leverage (DOL) (iv) Degree of
Financial Leverage (DFL) of ABC Company for 2002 if :
(i)Debt / Assets = 0%, (ii) Debt / Assets = 50%

Probability of Indicated sales

0.2
0.6
0.2
Sales (thousand)
$ 200 $ 400
$ 600
Fixed Cost (thousand)
(80)
(80)
(80)
Variable Cost (thousand)
(120) (240) (360)
Total Cost (Except Interest)
(200) (320 ) (440)
EBIT
00
80
160

 Assume the following:

(I) The firm is in the 40 percent tax

bracket
(ii) Cost of debt is 12 percent
(iii) The value per share of ABC Company
is $ 20
(iv) Total Capital of ABC Company is $
200000