CHAPTER 5

FINANCIAL DECISION (CAPITAL STRUCTURE AND LEVERAGE)

Capital structure represents the mix of different sources of long term funds (such as common stock,
preferred stock, long term bonds and retained earrings) in the total capitalization of the company.
The term Capital structure differ from financial structure
 Financial structure refers to the way of firms assets are financed. In other words it includes
both long term as well as short term source of fund.
 Capital structure is the permanent financing structure of the company represented primarily
by long term bonds and stock holders’ funds but excluding all short term credit. thus the
company’s capital structures only a part of its financial structure.

THE TARGET CAPITAL STRUCTURE

Capital structure policy involves a trade-off between risk and return:
 Using more debt raises the riskiness of the firm’s earnings stream
 However, a higher debt ratio generally leads to a higher expected rate of return
Higher risk tends to lower a stock’s price, but higher expected rate of return raises it. Therefore, the
optimal capital structure strikes a balance between risk and return so as to maximize a firm’s stock
price.
Four primary factors influence the capital structure decision
1. Business risk,
risk,
2. The firm’s tax position
3. Financial flexibility or the ability to raise capital on reasonable terms under adverse
conditions.
conditions.
4. Managerial conservatism or aggressiveness.
aggressiveness.
These four points larger determine the target capital structure, but operating conditions can cause
the actual capital structure to vary from the target.

CONCEPT OF LEVERAGE
Leverage results from the use of fixed assets or funds to magnify return to the firm’s owners.
 Increase in leverage results in increase risk and return.
 Leverage measures the behavior of interrelated variables such as output, revenue, EBIT and
EPS. Therefore
1. Leverage measures the relationship between two variables, as opposed to measuring
variables independently, and the value that one variable assumes must depend on the values
assume by the second variable.
2. The direction of casualty must be known.
 When two variables are so related, the degree of leverage describes the responsiveness of the
dependent variable to change in the independent variable.
Let Y and X represent two variables. Y is called the dependent variable and X is referred to as the
independent variable. The algebraic statement of Y’s dependence on X is written as:
Y = f (x)
And is read as: Y is a function of X
Suppose that the initial values of Y and X are known. The independent variable X now takes on a
new value. The change in the value of X and its percentage change are computed. The resulting
change and percentage change are also computed. Leveraged is then defined as the percentage
change in the dependent variable Y divided by the percentage change in the independent variable X.
in algebraic terms, the definition of leverage is developed as follows:

Let x = the change in the independent variable x

y = the change in the dependent variable y.
Δx
x = the percentage change in x = % x
Δy
y = the percentage change in y = % y
Then,
L ( y ) Δy / y
=
L ( x ) Δx /x
The left hand side of the above equation is read as: the leverage of y with respect to x.
1 Operating Leverage
Operating Leverage measures the relationship between output and Riming before interest and tax
(EBIT), specifically; it measures the effect of changing levels of output on EBIT. The functional
relationship between these two variables is:
y = f (Q),
Where, y = earnings before interest and tax
Q = number of units of output produced and sold
Earnings before interest and tax = Total revenue – Total variable cost – fixed cost.
y = QP – QV – F
Or y = Q (P – V) – F
When the level of output changes from its initial value, the initial value of EBIT also changes. Thus,
operating leverage is defined as the resulting percentage change in EBIT divided by the percentage
change in output, symbolically, operating leverage is expressed as:
L ( y) Δy/ y % Δ EBIT
= =
L (Q) ΔQ /Q % Δ output
T (P−V )
Short cut formula for operating leverages (OL/Q) = T ( P−V ) − F
Example: Assume that the price per unit of output (p) is Br. 10, and variable cost per unit of output
(y) is Br. 4, and fixed cost (F) is Br. 30,000, and the level of output (T) is 8000 units. By using the
formula EBIT is computed as follows:
y = Total revenue – Total variable cost – fixed cost
y = QP – QV – F
or y = Q (P – V) – F
y = 8000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 18,000
Now assume that the level of output increases from 8000 to 10,000 units. The resulting EBIT is
computed as:
y = 10,000 (Br. 10 – Br. 4) – Br. 30,000
= Br. 30,000
The coefficient of operating leverage is computed as follows:
Percentage change in output = 2000/8000 = 25%
Percentage change in EBIT = Br. 12000/Br. 18000 = 66.7%
L( y ) Δy/ y
=
L (Q) ΔQ /Q
L ( y) .667
=
L (Q) .25 = 2.67
By using Short cut formula for operating leverage
8000 (Br .10−Br . 4 )
= 2 . 67
(OL/Q) = 8000 (Br .10−Br . 4 )−30 , 000
Interpretation 1 percent change in output from an initial value of 8000 units produces a 2.67 percent
change in EBIT. Since output increased by 25 percent from its initial value of 8000 units, EBIT
increases by (2.67) (.25) = .667 or 66.7 percent.
Financial Leverage
It is defined as the potential use of fixed financial costs to magnify the effect of change in EBIT on
the firms EPS.
It measures the relationship between the effects of changing levels of EBIT on EPS. The functional
relationship between these two variables is:
EPS = f (EBIT)
Let EBIT = Y
EBT = Y – I
Taxes= (Y – I) (t)
Net income = (Y – I) (1 – t)
Earnings available to common shareholders
Net income– preferred stock dividends
(Y – I) (1 – t) – E
Earnings per share to common stock holders:
Earnings available to common shareholders
Number of common shares
EPS = (Y – I) (1 – t) – E
N
The algebraic equivalent of the complete income statement is obtained by substituting the symbolic
form of EBIT as follows:
[ Q(P − V ) − F − I ] (1−t ) −E
EPS = N
When the level of EBIT changes from its initial value, the initial value of EPS also changes.
Financial leverage is thus defined as the resulting percentage change in EPS divided by the
percentage change in EBIT. Symbolically, financial leverage is expressed as:
L ( EPS ) Δ EPS/ EPS % Δ EPS
= =
L ( EBIT ) Δ EBIT / EBIT % Δ EBIT
Y
E
Y−I −
Short cut formula for financial leverage (FL/Y) = 1−t
Example Assume that I = Br. 100,000, t = 0.4, E = Br. 80,000
N = 60,000, and EBIT = Br. 500,000. The EPS at this level of EBIT is
Computed as:
EPS = (Br. 500,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 2.67
If EBIT increases from Br. 500,000 to Br. 600,000, the resulting EPS is:
EPS = (Br. 60,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
60,000
= Br. 3.67
The financial leverage is computed as:
Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20%
Percentage change in EPS = Br. 1/Br. 2.67 = 37.45%
L ( EPS ) 0 . 3745
= = 1 . 87
L ( EBIT ) 0.2
Y
E
Y−I −
By using Short cut formula of financial leverage (FL/Y) = 1−t
500, 000
= 1. 87
Br . 80,000
Br .500 , 000−Br .100 ,000−
)= 1 − 0. 4

(FL/Y
Interpretation:-1
Interpretation:-1 percent change in EBIT from an initial value of Br. 500,000 produces a 1.87
percent change in EPS. Since EBIT increased by 20 percent from its initial value, EPS increased by
1.87 (0.20) = 0.374 or 37.4 percent.
 Note that EBIT is the independent variable when measuring financial leverage, but the
dependent variable when measuring operating leverage. As a result, EBIT, is sometimes
called the linking pin variable with respect to leverage application in finance.