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    Capital Structure and Leverage

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    alokshri25
    The document discusses capital structure and leverage. It defines capital structure as the proportionate relationship between debt and equity on a company's balance sheet. It then discusses features of an appropriate capital structure such as profitability, solvency, flexibility, and control. Finally, it summarizes different theories of capital structure such as the net income approach, net operating income approach, and Modigliani-Miller hypotheses with and without taxes.

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    Capital Structure and Leverage

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    alokshri25
    2K views31 pages
    The document discusses capital structure and leverage. It defines capital structure as the proportionate relationship between debt and equity on a company's balance sheet. It then discusses features of an appropriate capital structure such as profitability, solvency, flexibility, and control. Finally, it summarizes different theories of capital structure such as the net income approach, net operating income approach, and Modigliani-Miller hypotheses with and without taxes.

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    The document discusses capital structure and leverage. It defines capital structure as the proportionate relationship between debt and equity on a company's balance sheet. It then discusses features of an appropriate capital structure such as profitability, solvency, flexibility, and control. Finally, it summarizes different theories of capital structure such as the net income approach, net operating income approach, and Modigliani-Miller hypotheses with and without taxes.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    2K views31 pages

    Capital Structure and Leverage

    Uploaded by

    alokshri25
    The document discusses capital structure and leverage. It defines capital structure as the proportionate relationship between debt and equity on a company's balance sheet. It then discusses features of an appropriate capital structure such as profitability, solvency, flexibility, and control. Finally, it summarizes different theories of capital structure such as the net income approach, net operating income approach, and Modigliani-Miller hypotheses with and without taxes.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 31
    At a glance
    Powered by AI
    The key takeaways are about capital structure, leverage, and their impact on firm value.

    The different forms of capital structure are complete equity share capital, different proportions of equity and preference share capital, different proportions of equity and debenture capital, and different proportions of equity, preference and debenture capital.

    The determinants of capital structure are seasonal variations, tax benefit of debt, flexibility control, industry leverage ratios, agency costs, industry life cycle, degree of competition, company characteristics, requirements of investors, timing of public issue, and legal requirements.

    Capital Structure and

    Leverage
    Capital Structure Defined
    The term capital structure is used to represent the
    proportionate relationship between debt and equity.
    The various means of financing represent the
    financial structure of an enterprise. The left-hand
    side of the balance sheet (liabilities plus equity)
    represents the financial structure of a company.
    Traditionally, short-term borrowings are excluded
    from the list of methods of financing the firm’s
    capital expenditure.

    2
    Features of An Appropriate Capital Structure

     capital structure is that capital structure at that level of debt – equity proportion where
    the market value per share is maximum and the cost of capital is minimum.
    Appropriate capital structure should have the following features
     Profitability / Return

     Solvency / Risk

     Flexibility

     Conservation / Capacity

     Control
    Determinants of Capital Structure
     Seasonal Variations
     Tax benefit of Debt
     Flexibility
     Control
     Industry Leverage Ratios
     Agency Costs
     Industry Life Cycle
     Degree of Competition
     Company Characteristics
     Requirements of Investors
     Timing of Public Issue
     Legal Requirements
    Patterns / Forms of Capital Structure

    Following are the forms of capital structure:


     Complete equity share capital;
     Different proportions of equity and preference share capital;
     Different proportions of equity and debenture (debt) capital and
     Different proportions of equity, preference and debenture (debt) capital.
    Debt-equity Mix and the Value of the Firm
     Capital structure theories:

     Net operating income (NOI) approach.

     Traditional approach and Net income (NI) approach.

     MM hypothesis with and without corporate tax.

     Miller’s hypothesis with corporate and personal taxes.

     Trade-off theory: costs and benefits of leverage.


    Assumption of Capital Structure Theories
    There are only two sources of funds i.e.: debt and equity.
     The total assets of the company are given and do no change.
     The total financing remains constant. The firm can change the degree of leverage either
    by selling the shares and retiring debt or by issuing debt and redeeming equity.
     Operating profits (EBIT) are not expected to grow.
     All the investors are assumed to have the same expectation about the future profits.
     Business risk is constant over time and assumed to be independent of its capital
    structure and financial risk.
     Corporate tax does not exist.
     The company has infinite life.
     Dividend payout ratio = 100%.
    Net Income (NI) Approach
    This theory is propounded by David Durand. According to this
    approach capital structure decisions regarding leverage or dept-equity
    mix exercise an important impact on the value of the firm. An increase
    in the degree of leverage or debt in the capital structure will bring
    down the overall cost of capital (Ko) and will increase the total market
    value of the firm, resulting in raising the market price of equity shares
    and vice versa.
    The inter-relationship between financial leverage , cost of capital and
    value of the firm holds certain assumptions:
     There are no taxes.
     The rate of interest on dept (Ki) is lower than rate of return on equity
    shareholder.
     The investors perceive no change in financial risk.
    Net Income (NI) Approach
     According to NI approach both the cost Cost

    of debt and the cost of equity are


    independent of the capital structure;
    they remain constant regardless of how
    ke, ko ke
    much debt the firm uses. As a result, the
    overall cost of capital declines and the
    ko
    firm value increases with debt. kd kd

     This approach has no basis in reality;


    the optimum capital structure would be
    Debt
    100 per cent debt financing under NI
    approach.
    Net Operating Income (NOI)Approach
    This theory is also propounded by David Durand. According to this
    approach the overall cost of capitalization (Ko) remains constant . It
    has no relation with capital structure which means that overall
    capitalization rate is independent of changes in capital structure
    through variations in debt- equity mix. Investors determine the total
    value of the firm on the basis of Ko.
    Cont..
    As contrary to NI approach ( in which Ke was considered to
    be constant ) but the rate of return to equity shareholders
    Ke is not constant under NOI approach and will increase
    with every increase in financial leverage, because of
    increased financial risk for equity holders, it does not
    compensate the existing shareholders for enhanced risk
    and this will increase the rate of return on their equity
    capital, this raise the cost of equity share capital (Ke). In
    case the firm does not increases rate of return due to
    increase in leverage then the shareholders may start selling
    their shares and this will bring down market value of shares.
    Net Operating Income (NOI) Approach
     According to NOI approach the
    value of the firm and the weighted
    average cost of capital are Cost
    ke
    independent of the firm’s capital
    structure.
     In the absence of taxes, an ko

    individual holding all the debt and kd


    equity securities will receive the
    same cash flows regardless of the
    Debt
    capital structure and therefore,
    value of the company is the same.
    Traditional Theory
    The traditional theory of capital structure is an intermediary approach
    which reconciles NI and NOI approaches. This theory assumes that :
     There is relevance of capital structure and through proper increase in
    leverage or debt- equity mix a firm can have a optimum capital
    structure in which the total market value(v) of the firm will be
    maximum and overall cost of capital minimum.
     The overall cost of capital is affected by capital structure decisions.
     Beyond a particular point increase in leverage causes rise in equity
    capitalization rate(Ke) at a rapid rate
    MM Approach Without Tax: Proposition I

     MM’s Proposition I states that the firm’s value is


    independent of its capital structure. With personal
    leverage, shareholders can receive exactly the same
    return, with the same risk, from a levered firm and an
    unlevered firm. Thus, they will sell shares of the over-
    priced firm and buy shares of the under-priced firm until
    the two values equate. This is called arbitrage.
    Cont…
    This approach closely resembles NOI approach so far as the theme of
    irrelevance of capital structure in determining V and Ko are concerned.
    Both the approaches contend that Ko is independent of the degree of
    leverage in capital structure and hence the value of the firm in not
    affected by financing decisions.
    MM approach, provides rational explanation
    ( which is ignored in NOI approach) that there is no inter-relationship
    between cost of capital and debt- equity ratio.
    The assumptions of MM approach are as follow:
     The capital markets are perfect.
     There are no transaction costs.
     All the firms can be classified into equivalent risk or group or
    homogeneous risk category.
     100% dividend payout ratio
    Cont..
    It may be pointed that the entire MM theme is built up on the process
    known as arbitrage.
    Meaning of arbitrage:- Simultaneous purchase and sale of the same
    or equivalent security in order to profit from price discrepancies.
    The process of arbitrage balances the discrepancies and restores an
    equilibrium in V and Ko of the two firms.(belonging to same risk
    class), In case the V of a levered firm is higher and Ko is lower as
    compared to unlevered firm , the rational investor will start selling
    their proportionate shares in the levered firm and purchase equivalent
    share in equity of the unlevered firm.
    By doing so the rational investors will be having the benefit of the same
    return after arbitrage.
    MM Hypothesis With Corporate Tax

     Under current laws in most countries, debt has an important advantage over
    equity: interest payments on debt are tax deductible, whereas dividend payments
    and retained earnings are not. Investors in a levered firm receive in the aggregate
    the unlevered cash flow plus an amount equal to the tax deduction on interest.
    Capitalising the first component of cash flow at the all-equity rate and the second
    at the cost of debt shows that the value of the levered firm is equal to the value of
    the unlevered firm plus the interest tax shield which is tax rate times the debt (if
    the shield is fully usable).
     It is assumed that the firm will borrow the same amount of debt in perpetuity and
    will always be able to use the tax shield. Also, it ignores bankruptcy and agency
    costs.
    Features of an Appropriate Capital Structure

     Profitability
     Solvency
     Return 
     Risk 
     Flexibility 
     Capacity
     Control
     Conservatism
    CONCEPT OF LEVERAGE
    The leverage may be defined as the % change in one variable
    divided by the % change in some other variable or variables.
    The term leverage in general, refers to a relationship
    between two interrelated variables, with reference to
    business firm. These variables may be costs, sales revenue,
    EBIT, earning per share etc. In the leverage analysis, the
    emphasis is on the measurement of the relationship of these
    variables rather then on measuring these variables.
    TYPES OF LEVERAGE
    1. Operating Leverage
    2. Financial Leverage
    3. Combined Leverage
    OPERATING LEVERAGE
    When a firm operates with heavy fixed costs in relation to
    its total operating cost. If a high percentage of a firm’s total
    costs are fixed costs, then the firm is said to have a high
    degree of operating leverage. Use of high fixed operating
    costs does magnify a change in profits relative to a give
    change in sales.
    In other words, it can be said that when
    operating leverage is high , a slight favourable or
    unfavourable change in sales will cause a more favourable
    or unfavourable change in operating profits or EBIT of the
    firm
    Meaning of Financial Leverage
    The use of the 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.

    The financial leverage employed by a company is intended to earn more


    return on the fixed-charge funds than their costs. The surplus (or deficit)
    will increase (or decrease) the return on the owners’ equity. The rate of
    return on the owners’ equity is levered above or below the rate of return on
    total assets.
    FINANCIAL LEVERAGE

    Financial leverage indicates the impact of debt financing on


    the earnings ( profit before tax ) of the firm. High financial
    leverage represents a higher proportion of borrowed funds
    in the total capitalization of the company . Capital
    structure with a high degree of financial leverage creates a
    heavy fixed burden on the profits which can be sustained
    till sales earnings are adequate
    COMPUTATION OF FINANCIAL LEVERAGE

    FL= Financial leverage


    EBIT= Earnings before interest and tax
    INT= Interest on borrowed capital
    PBT= Profit before tax
    Financial Leverage and the Shareholders’ Return

    The primary motive of a company in using financial leverage is to

    magnify the shareholders’ return under favourable economic

    conditions. The role of financial leverage in magnifying the return

    of the shareholders’ is based on the assumptions that the fixed-

    charges funds (such as the loan from financial institutions and

    banks or debentures) can be obtained at a cost lower than the

    firm’s rate of return on net assets (RONA or ROI).

     EPS, ROE and ROI are the important figures for analysing the

    impact of financial leveraged


    Effect of Leverage on ROE and EPS

    Favourable ROI > I


    Unfavourable ROI < I
    Neutral ROI = I
    COMBINED LEVERAGE
    The OL explains the business risk complexion of the firm
    where as the FL deals with the financial risk of the firm.
    Both these leverage exercise a combined impact on the
    earnings of a firm. Operating leverage exercise a
    considerable or decelerating impact on the rate of return
    on overall investment in relation to change in the size of
    the sales which involves business risk.

    OR
    EPS and ROE Calculations

    Profit after tax


    Earnings per share =
    Number of shares
    PAT ( EBIT  INT )( 1  T )
    EPS = 
    N N

    Profit after tax


    Return on equity =
    Value of equity
    (EBIT  INT)(1  T )
    ROE =
    S

    For calculating ROE either the book value or the


    market value equity may be used.

    28
    Effect of Financial Plan on EPS and ROE: Constant EBIT
    The firm is considering Financial Plan
    two alternative financial Debt- All
    plans: Equity Equity
     (i) either to raise the entire Earning before 120000 120000
    interest & tax (EBIT)
    funds by issuing 50,000
    ordinary shares at Rs 10 per Less:- Interest 37500 -
    share, or Earning before tax 82500 120000
     (ii) to raise Rs 250,000 by PBT=EBT-INT
    issuing 25,000 ordinary Less:- Taxes 41250 60000
    shares at Rs 10 per share
    and borrow Rs 250,000 at 15 Profit after tax(PAT) 41250 60000
    per cent rate of interest.
    Total earnings of 78750 60000
    The tax rate is 50 per cent. investor (PAT+INT)

    29
    Combining Financial and Operating
    Leverages
    Operating leverage affects a firm’s operating
    profit (EBIT), while financial leverage affects
    profit after tax or the earnings per share.
    The degrees of operating and financial
    leverages is combined to see the effect of total
    leverage on EPS associated with a given change
    in sales.

    30

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