You are on page 1of 13

CAPITAL STRUCTURE AND LEVERAGES

Meaning of Capital Structure


Capital Structure: Include only long-term debt and total stockholder investment Capital Structure = Long-term Debt + Preferred
Stock + Net worth (or)

Capital Structure = Total Assets Current Liabilities

Optimum Capital structure


Optimum Capital Structure: The level of debt equity proportion where market value of share is maximum, and cost of capital is minimum Features: Profitability Solvency Flexibility Conservatism Control

Patterns of Capital Structure


1. Complete equity share capital; 2. Different proportions of equity and preference share capital; 3. Different proportions of equity and debenture (debt) capital an 4. Different proportions of equity, preference and debenture (debt) capital.

Indifferent point
Point of Indifference: The level of EBIT at which EPs is same for two alternative capital structures
(X I1) (1 t) PD (1 + Dt) ES1 = (X I2) (1 t) PD (1 + Dt) ES2

Where: X = EBIT I1,I2 = Interest under alternatives 1 and 2 t = Tax rate PD = Preference dividend Dt = Preference dividend tax ES1, ES2 = No. of equity share outstanding under alternative 1 and 2

CAPITAL STRUCTURE & LEVERAGE


THEORIES OF CAPITAL STRUCTURE Net Income Approach : This theory propounds that a firm can increase its value & reduce the overall cost of capital by increasing the proportion of debt in its capital structure. Assumptions : This theory assumes following assumptions 1.The cost of debt is less than the cost of equity 2.There are no taxes 3.The risk perception of investors is not changed by the use of debt Net Operating Income Approach : Suggested by Durand, Change in the capital structure of a firm does not affect the market value of the firm & the overall cost of capital remains constant irrespective of the method of financing Important term used : V = Market Value of Firm, S = Market value of Equity B = Value of Debt, I = Interest on debt

Traditional Approach
Also known as intermediate approach, is a compromise between the two extremes of NI & NOI approach. According to this theory the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is the cheaper source of funds than equity. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt. Thus overall cost of capital, according to this theory, decreases up to a certain point, remains more or less unchanged for moderate increase in debt thereafter; & increases or rises beyond a certain point. Even the cost of debt may rise at this stage due to increased financial risk.

MODIGLIANI & MILLER APPROACH


M&M hypothesis is identical with the NOI approach if taxes are ignored. However, if taxes are considered , their hypothesis is similar to the NI approach. In absence of taxes: The theory proves that the cost of capital is not affected by changes in the capital structure. The reason argued is that though debt is cheaper to equity, with increased use of debt as a source of finance, the cost of equity increases. This increased cost of equity offsets the advantage of the low cost of debt. Thus, although the financial leverage affects, the cost of equity, the overall cost of capital remains constant. In the opinion of Modigliani & Miller, two identical firms in all respects except their capital structure cannot have different market values or cost of capital because of arbitrage process. In case two identical firms except for their capital structure have different market values or cost of capital arbitrage will take place 7 the investors will engage in personal leverage as against corporate leverage; & this will again render the two firms to have the same total value. When the corporate taxes are assumed : Modigliani & Miller, in their article of 1963 have recognised that the value of firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charges for tax purpose.

Leverage
Leverage: The action of a lever and mathematical advantage gained by it Types of Leverages: Operating leverage Financial leverage

Operating Leverage
Operating Leverage: The firms ability to use operating cost to magnify the effects of changes in sales on its EBIT
Degree of Operating Leverage (DOL) = Percentage change in EBIT Percentage change in Sales Or

When the data is given only for one year, then we have to compute operating leverage, by the following formula. Operating =
Leverage Contribution Operating Profit (EBIT)

Financial Leverage
Financial Leverage: Ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on firms EPS
Financial Leverage = EBIT (Operating profit) EBT (Taxable income) Degree of Financial Leverage (DFL) Percentage change in EPS Or

Percentage change in EBIT

Combined Leverage
Combined leverage: The percentage change in EPS due to the percentage change in sales
% Change in EBIT X % Change in Sales % Change in EPS % Change in EBIT Or Contribution EBIT X EBIT EBT = Contribution EBT = % Change in EPS % Change in Sales

Effect of Leverage on Firm


Operating Leverage High Low High Financial Leverage High Low Low Combined Effect This combination is very dangerous policy, which should be avoided. This combination is very cautious policy and not assuming risk. This combination have adverse effects of operating leverage were taken care of by having low financial leverage. This combination is an ideal situation. The company can follow aggressive debt policy.

Low

High

You might also like