Financial Management

BBA 5th Prepared By Adnan Khan Lecturer in Finance

Capital Structure Basics

Chapter # 13

Capital Structure


Capital structure is the mixture of funding sources (debt, preferred stock or common stock) that a firm uses to finance its assets. The amount of debt that a firm uses to finance its assets creates leverage. A firm with a lot of debt in its capital structure is said to be highly levered and, with no debt is said to be unlevered. The power of leverage can also be harnessed in a financial settings

Types of leverage

1.

The degree to which an investor or business is utilizing borrowed money is called leverage. Operating Leverage  It shows the ratio between the changes in EBIT and sales in presence of fixed cost  The percentage of fixed costs in a company's cost structure.  The higher the operating leverage, the more a company's income is affected by fluctuation in sales volume.

Calculating Degree of operating leverage

  

It measures the magnitude of the operating leverage DOL= % EBIT/% sales Or DOL:= Sales- VC / Sales-VC-FC SalesSales-VC-

Risk of operating Leverage

2.

Financial Leverage  Financial leverage is additional volatility of net income caused by the presence of fixed cost funds in the firms capital structure.  Degree of Financial Risk  If refers to the % age change in Net Income divided by %age change in EBIT  DFL=% NI/% EBIT Or DFL= EBIT/EBIT I  Where  EBIT = Earning before interest and taxes  I = Interest


Risk of Financial Leverage

3.

Combined Leverage  The combined effect of the operating and financial leverages is known as combined leverage  Degree of Combined Leverage  DCL is the percentage change in the Net income divided by percentage change in sales.  DCL= % NI/% Sales Or DCL= Sales VC/ Sales-VC-FC-I Sales-VC-FCOr DCL= DOL*DFL
   

Where VC= Variable cost FC= Fixed Cost I = Interest

Fixed Cost and Combined Leverage  Fixed operating cost creates operating leverage and fixed financial cost creates financial leverage.  If either, or both, fixed operating cost and fixed financial cost exceeds zero, a leverage effect will be occur (DCL>1)

Breakeven Analysis and Leverage



 

The point where the operating profit is equal to zero or (Sales= Cot) The fixed cost effecting the firm value because of leverage effect and the resulting risk from those leverage effect Breakeven analysis is a key to understanding operating leverage. The sales breakeven point is the level of sales that a firm must reach to cover its operating costs. High/low trade-off in breakeven analysis trade-

Constructing a Sales Breakeven Chart



A breakeven chart shows the graphical relationship of fixed cost , variable cost and the sales volume First find the breakeven point  Qbe = FC/P-VC FC/P   

Where Qbe= Quantity sales breakeven FC= Fixed Cost P= Price VC= Variable Cost

Second to find the revenue data



Total revenue = p*Q Total Cost(TC)= FC+ (VC*Q)

Third to find the Cost Data



Forth Plotting data on Breakeven Chart