CAPITAL STRUCTURE

The firm combines different securities in its assets in an

attempt to maximize its overall market value. Capital structure in
this sense is the firm’s mix of different sources of finance. It refers to
the way a firm finances its assets through some combinations

of equity, debt, or hybrid securities. A firm's capital structure

in this respect is then the composition or structure of its

liabilities but excluding all short term liabilities.
Basically, a firm’s major source of finance is debt and equity. Equity
includes paid up share capital, share premium, reserves and surplus
while debts includes debentures, loan stocks and bonds.
Clearly defined therefore, capital structure refers to the
relative mix of or the proportionate relationship between debt
and equity securities in the long-term financial structure of a
company.
The capital structure decision is a significant managerial and strategic
decision. It influences the shareholders return and risk. Consequently,
the market value of the share may be affected by the capital structure
decision. Thus, whenever funds have to be raised to finance
investments, a capital structure decision is involved.
Hence, the debt-equity mix has implications for the
shareholders’ earnings and risk, which in turn will affect the
cost of capital and the market value of the firm.

OPTIMAL OR TARGET CAPITAL STRUCTURE

The Optimal Capital Structure is the one that minimizes
the firm’s cost of capital and maximizes its value. It is
the mix or combination of debt, preference shares
and equity that will optimize or maximize the
company's share price and minimize its WACC. As a

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 company raises new capital it will focus on maintaining
this target or optimal capital structure.

For each company, there is an optimal capital

structure, including a percentage of debt and equity, a
balance between the tax benefits of the debt and the
equity. As a company continues to increase its debt over
the amount stated by the optimal capital structure, the
cost to finance the debt becomes higher as the debt is
now riskier to the lender. The risk of bankruptcy increases
with the increased debt burden. Since the cost of debt
becomes higher, the WACC is also affected. With the
addition of debt, the WACC will at first fall as the
benefits are realized, but once the optimal capital
structure is reached and then surpassed, the increased
debt burden will then cause the WACC to increase
significantly.

CAPITAL STRUCTURE, OPTIMALITY AND THE

VALUE OF A FIRM
The Capital Structure decision of a firm and its optimality are usually
examined from the point of its impact on the value of the firm. If capital
structure decision can affect a firm’s value, then the firm would like to
have a capital structure, which maximizes its market value.

The appropriate questions to ask here is;

‘Is there an optimal capital structure? Does capital structure matter? If
it does, what is the relationship between capital structure and the value
of the firm? Can the total market value of a firm be increased or
decreased by changing the mix of debt and equity financing?’

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The answer to these questions are not farfetched but lies on two
conflicting theories well documented in the literature and established to
explain the relationship between capital structure, optimality and the
value of the firm. These theories include;

• Theories of Capital Structure Relevance and

• Theories of Capital Structure Irrelevance

In establishing this relationship, certain simplifying assumptions
common to these theories were proposed including;
i. Firms can be financed only through debt and equity

ii. Transaction or floatation cost does not exist

iii. Corporate or personal income taxes does not exist
iv. The ratio of debt to equity of a firm can be changed by
issuing debt to purchase equity or issuing equity to pay
off debt.
v. Bankruptcy costs do not exist.

vi. Individuals can borrow as easily and at the same rate of

interest as the firm.
vii. There are no retained earnings. The firm pays out 100%
of its earnings as dividend.
viii. The operating earnings of the firm are not expected to
grow.
ix. The expected value of the probability distributions of
expected future operating earnings for each company are
the same for all investors in the market.

THEORIES OF CAPITAL STRUCTURE RELEVANCE

Among the leading theories documenting the relevance of capital
structure to the firm’s value includes;
• Net Income Approach
• Traditional Approach

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 • Modigliani and Miller (M&M) Theory with
Taxes

NET INCOME APPROACH

This theory posits that capital structure is relevant and that the
proportionate use of debt in a firm’s capital structure will increase its
value. It suggests that a firm can vary its value by either increasing or
decreasing it through the financial mix, which is the ratio of debt to
equity. The NI approach is based on the premise that the cost
of debt is cheaper than that of equity and that the optimal
use of debt will result in a decline in WACC.

According to this approach, the average cost of capital (k o) declines

as gearing increases. The cost of shareholders funds (ke) and the cost
of debt (kd) are independent. Since kd is usually less than ke as debt
is less risky than equity from the investor’s point of view, an increase
in gearing should lead to a decrease in ko

As the proponent puts it, the cost of debt is cheaper than

that of equity for the following reasons;
i. Lenders require a lower rate of return than ordinary
shareholders. Debt finance presents a lower risk than shares for
the finance providers because they have prior claims on annual
income and liquidation. In addition security is often provided and
covenants imposed.
ii. A profitable business effectively pays less for debt capital
than equity since debt interest can be offset against pre-tax
profits before the calculation of company tax, thus reducing
the company’s tax liabilities.
iii. Issuing and transaction costs associated with raising and
servicing debt are generally less than for ordinary shares.

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The Net Income approach can be demonstrated graphically as
follows;

Rate
Of
Return
(%)

Ke

Ko

KD

Debt/Equity

As shown, the cost of equity is constant throughout. An increase in

the level of gearing is consistent with a reduction in the cost of
capital. Thus, as a firm introduces more debt into its capital
structure, the overall cost of capital will decline.
Clearly, the amount of debt that a firm uses to finance its assets is
called leverage. A firm that finances its assets by equity and debt is
called a LEVERED/GEARED firm while a firm that finances its assets
entirely with equity is an UNLEVERED firm.
Hence, under the NI approach;

Cost of Debt (Kd) = Interest

Market Value of Debt

Cost of Equity (Ke) = Earnings available to shareholders

Market value of shares outstanding

Value of the firm (V) = Mkt value of Debt + Mkt value of

equity

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 (V) =D+E

Accordingly, under this approach, the firm’s overall cost of capital or

expected rate of return (WACC) is expressed as;
Cost of capital = Net Operating Income
Value of firm

Ko = NOI
V

On the whole, under this approach, the firm will achieve its maximum
value and minimum WACC (Optimality) when it is 100% Debt
financed.

TRADITIONAL APPROACH
The traditional approach observed that capital structure is relevant
and argued that there is an optimal capital structure and that the
judicious use of debt finance will lead to a reduction in the cost of
capital until an optimum level is reached.
Gearing beyond the optimal level will lead to an increase in
the cost of capital. The argument is that as companies introduces
debt into its capital structure; the WACC will fall due to the theoretical
lower cost of debt compared with equity finance.
As the level of debt increases, the return required by
ordinary shareholders will start to rise due to the following
reasons;

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 • The equity provider starts to get worried over the
adequacy of the operating profit to meet the huge debt
interest and still pay dividend.
• Equity providers are equally worried over the possibility
that debenture holders can interfere with the
management of the company.

• The possibility of the company been forced into

liquidation in the event of failure to meet loan interest
payment.
As the returns required by equity holders increases, WACC
will still continue to fall until it reaches a point where
providers of debt will equally demand for higher returns
because;
• A higher level of operating income will be required to meet the
ever increasing debenture interest;
• There may be no adequate physical asset to secure additional
loan or debenture.

Graphically, this can be expressed as follows;

Rate
Of
Return
Ke

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 Ko

Kd

D/E
Optimum = minimum Ko.

WACC decreases up to a certain level of debt and reaching the

minimum level, starts increasing with financial leverage. Optimal
capital structure is reached where Ko is minimum at which point the
value of the firm is maximised.
Clearly, cost of capital will decrease initially with the use of debt. But
as leverage increases further shareholders start expecting higher risk
premium in the form of increasing cost of equity until a point is
reached at which the advantage of lower cost of debt is more than
offset by more expensive equity.
On the whole, under this approach, capital structure is only relevant
up to the optimal level. This is the point where the cost of debt and
WACC is at its minimum.

M & M HYPOTHESIS WITH TAXES

In their 1963 article, MM showed that capital structure is relevant and
that the value of the firm will increase with debt due to the
deductibility of interest charges for tax computation since leverage
lowers tax payment. Hence, the value of the levered firm will be
higher than that of the unlevered firm.
The interest tax shield/tax advantage is the tax savings that occur on
account of payment of interest to debt holders. The interest tax
shield is a cash inflow to the firm and therefore, it is valuable.
According to them, this interest tax shield can be computed as
follows;

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 PV of Interest tax shield = (Corporate tax) x (Interest Rate)
Cost of debt

Graphically, this can be shown as follows;

Clearly, with interest tax shield allowed for levered firms, debt
financing is more advantageous than equity financing. Thus, the
optimum capital structure is reached when the firm employs
almost 100% debt.

FINANCIAL LEVERAGE WITH CORPORATE vs. PERSONAL TAX

Companies pay corporate tax on their earnings. Hence, the earnings
available to investors are reduced by the corporate tax. Further,
investors are required to pay personal taxes on the income earned by
them. Therefore, from the point of view of investors, the effect of
taxes will include both company and personal taxes.
A firm should thus aim at minimizing the effect of total taxes (both
corporate and personal) to investors while deciding about borrowings.

IRRELEVANCE OF CAPITAL STRUCTURE

Two theories established the irrelevance of capital structure. These
are the following;

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 • Net Operating Income Approach

• Modigliani and Miller (M&M) without taxes

NET OPERATING INCOME (NOI) APPROACH

According to this approach popularized by David Durand, the
overall value of the firm and the cost of capital have no relationship
with and are independent of the capital structure and therefore
capital structure is totally irrelevant.

According to the proponent, an increase in debt increases the financial

risk of the shareholders, as they are responsible for the
repayment of the debt. Further increases in leverage will
result in shareholders demanding a higher rate of return on
their investment, hence increasing the cost of equity to a point
that the advantage of cheap debt will be completely wiped out by
the increase in the cost of equity. However, the overall cost of
capital is unaffected and thus remains constant irrespective of the
change in the ratio of debts to equity capital.

Accordingly, the approach decomposed the cost of capital

into two cost elements namely;
(i) The low explicit cost, represented by interest charges on
Debentures/debt and the
(ii) High implicit cost which results from the increase in cost of
equity caused by an increase in the degree of leverage

As a result, the advantage gained in terms of lower cost of

debt (explicit cost) will be neutralized by the disadvantage
in term of high cost of equity (implicit cost). Therefore the cost
of debt and equity will be the same in all capital structures.

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With this approach, to obtain the total market value of the firm, the
Net Operating income (NOI) of the firm is capitalized at an
overall rate of return. The market value of debt is then
deducted from the total market value of the firm to obtain the
market value of shares.

Thus, under this approach;

Value of the Levered firm = Value of Unlevered firm

Value of the firm (VL) = NOI

Opportunity cost of capital

Ko = NOI
VL

Ke = NOI – Debt. Interest

MVe

This approach is based on the assumption that the overall company’s

cost of capital and cost of debt are constant for all degrees of
leverage and the cost of equity increases linearly with that of
leverage, so that the advantage of cheap debt is completely offset by
increasing equity.

Graphically, this can be shown as follow;

KE

Rate
Of
Return

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 KO

KD

Debt/Equity

Overall, under the NOI approach, an optimal capital

structure of a firm does not exist. All capital structures
according to the theory are optimal. The increase in ke is exactly
sufficient to offset the effect of the increased importance of kd so ko
is constant.

MM HYPOTHESIS WITHOUT TAXES

Franco Modigliani and Merton Miller in their original 1958 article
observed that in perfect capital markets without taxes, bankruptcy
and transaction costs, a firm’s market value and the cost of capital
remains invariant to the capital structure changes. The value of
the firm depends on the earnings and risk of its assets
(Business risk) rather than the way in which assets have
been financed.
MM began their proposition by making the following assumptions;
1) All physical assets are owned by the firm
2) Capital markets are frictionless. There are no corporate or
personal Income taxes, securities can be purchased or sold
costlessly and instantaneously.
3) Firms can issue only 2 types of securities, risky equity and
risk free debt.
4) Investors have homogenous expectations about future
stream of profits.

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 5) All investors have complete knowledge of what
future returns will be.
6) All firms within an industry have the same risk
regardless of capital structure
7) No transactions, agency and bankruptcy costs.
8) Individuals can borrow or lend as easily and at the
same rate of interest as the firm.
9) All earnings are paid out as dividends. Thus,
earnings are constant and there is no growth.
10) The average cost of capital is constant

Given these assumptions, the MM hypothesis can best be

explained in terms of their 2 propositions as follows;
• Proposition I
• Proposition II

PROPOSITION I

Consider two firms which are identical (In the same business risk
class, having the same beta and WACC) but different only in their
capital structures. The first firm is unlevered while the other is

13
levered. M&M argued that the two firms must have

identical total values. If they did not, individual

investors would engage in arbitrage and create
homemade leverage and the market forces that would
drive the two values to be equal.

To demonstrate this, suppose an investor is considering buying

one of the two firms Unlevered or Levered. Instead of purchasing
the shares of the levered firm, he could purchase the shares of
unlevered firm and borrow the same amount of money B
that the levered firm does. The eventual returns to either of
these investments would be the same. Therefore the price of the
levered firm must be the same as the price of the unlevered
firm minus the money borrowed, which is the value of the
levered firm’s debt.

Essentially, M&M approach is a Net operating Income

approach
because the value of the firm is the capitalized value of NOI. That is;

V = NOI
Ko

Since no taxes have been assumed, the operating income (EBIT) is

equivalent to the net income which is all paid out as dividends.
Thus, the value of the firm is equal to;

V = EBIT
Ka

Since the value of the firm is equal to the sum of the value of the
debt and equity;

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 V =D +E.......... .......... .......... ........ i
then
k 0V =k o ( D +E )......... .......... ........ ii
and
E D
ko =k e ( ) +k d ( )........ iii
D +E D +E

Substituting equation (iii) into (ii), and solving for Ke;

D
ke = ko + ( k o − k d )
E

Thus, ke must go up as debt is added to the capital structure.

%
Ke

Ko

Kd

Debt/Equity

Clearly, the basis of MM Proposition I argument is an

arbitrage process and homemade leverage creation.

ARBITRAGE
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Arbitrage is the riskless, instantaneous process of buying an asset in
one market at a low price, and then reselling it in another market
where the identical asset is selling at a higher price.
Under the arbitrage process, shareholders can switch
between two firms that are identical in all respects except
their degree of leverage. This means that if one of the firms is
considered highly levered, the investors would sell their shares and
buy those of the unlevered firm. This switching process will
continue until the value of both firms is the same.

Two (2) types of arbitrage can be distinguished, including;

• Real Arbitrage and
• Reversed Arbitrage.

REAL ARBITRAGE
Real arbitrage involves the switching by an investor from a levered
firm to an unlevered firm to take advantage of lower risk, increase
in income and sustained income.
For instance, when the value of levered firm is
higher than that of an unlevered firm;
i. An Investor will sell his investment held in that firm

ii. He will borrow propionate to his share of the debt of

the levered firm (at same interest rate)

iii. He will purchase securities of the un-levered firm

equal to his percentage equity holding in the

levered firm
iv. In this switching process, he will earn from the un-

levered firm the same as compare to levered firm

with reduced investment outlay or higher income
as compare to levered firm with full investment
outlay.
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REVERSE ARBITRAGE
Reversed arbitrage is the process of switching from an unlevered
firm to a levered firm to take advantage of increase in earnings and
guaranteed constant income.
For instance, when the value of un-levered firm is
higher;
i. An investor will sell his investment held in that firm

ii. He will buy securities of the levered firm equal to his

percentage holding in un-levered firm (both equity

shares and debt)
iii. In this process he will gain same income as compare

to levered firm with reduced outlay or higher

income as compare to levered firm with full
investment outlay.
On the basis of the arbitrage process, M&M concluded that
the capital structure decision of a firm does not matter and
is therefore IRRELEVANT. Whatever the financing mix adopted,
the market value of the firm remains the same and it does not help
in creating any wealth for shareholders.

HOMEMADE LEVERAGE
Homemade or personal leverage is the idea that as long as
individuals borrow (or lend) at the same rate as the firm, they
can duplicate the effects of corporate leverage on their own. Thus, if
levered firms are priced too high, rational investors will simply
borrow on personal accounts to buy shares in unlevered firms.

It is a technique individual investors can use to synthetically adjust

the leverage of a firm. Basically, in order to replicate the effects of
leverage in the firm, the individual investor borrows money at the

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same borrowing rate as the company and adds leverage to his
portfolio.

However, in practice, substituting homemade leverage for corporate

leverage in an individual investor’s portfolio will not reflect
corporate leverage exactly.

PROPOSITION 11
According to M&M, the cost of equity Ke will increase enough to
offset the advantage of cheaper cost of debt so that the opportunity
cost of capital (Ko) does not change.

M&M Proposition II argued that the value of the firm depends on

three factors including;

i. Required rate of return on the firm's assets (Ke)

ii. Cost of debt of the firm (Kd)
iii. Debt/Equity ratio of the firm (D/E)

The excessive use of debt increases the risk of default. Hence, in

practice, the cost of debt will increase with high level of financial
leverage. MM argued that when Kd increases, Ke will increase at a
decreasing rate and may even turn down eventually.

This proposition can be demonstrated graphically as follows;

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A careful perusal of the graph shows that Ke is upward sloping with
a slope of (Ko – Kd). The reason for this behaviour of Ke is
because as a company borrows more debt and increases its
Debt/Equity ratio, the risk of bankruptcy becomes higher. Since
adding more debt is risky, the shareholders demand a higher rate of
return (Ke) from the firm's business operations.

As leverage (D/E) increases further, Ke continues to increase

but the WACC remains the same even if the company borrows
more debt and increases its Debt/Equity ratio. Ko therefore does not
have any relationship with the D/E ratio. This is the basic identity
of M&M Proposition I and II, that the capital structure of the
firm does not affect its total value.

The conclusion germane from M&M analysis is that capital structure

is irrelevant. Therefore, there is no optimal capital structure for the
firm.

CRITICISMS OF MM IRRELEVANCE HYPOTHESIS

The arbitrage process is the behavioural foundation of MM’s

hypothesis. The arbitrage process may fail to bring equilibrium in
the capital market for the following reasons;
i. Lending and borrowing rate discrepancy.

ii. Non- substitubility of personal and corporate leverage.

iii. Transaction costs exist.

iv. Institutional restrictions.

v. Information asymmetry

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 vi. Existence of Corporation tax.

Clearly, it is incorrect to assume that Personal leverage is a perfect

substitute for corporate leverage. The existence of limited liability of
firms in contrast with unlimited liability of individuals clearly places
individuals and firms on a different footing in the capital market. In
a levered firm, all investors stand to lose to the extent of the
amount of the purchase price of their shares. But, if an investor
creates personal leverage, then in the event of the firm’s
insolvency, he would lose not only his principal in the shares of the
unlevered firm, but will also be liable to return the amount of his
personal loan.

MM PROVIDED THE FOLLOWING FORMULA

WITH TAXES:

i. Ko = KeVe + KoVo (1 –t)

(Ve +Vd) (Ve + Vd)

ii. KEG = Keu + (Keu - Kd)(Vd) (1 - t)

(Veg)

Where: Keg = Cost of equity of geared firm

Veg = Value of equity of geared firm
Keu = Cost of equity of ungeared firm

iii. Kog = kou(1- VDt )

Vg

iv. Vg = Vu + VDt

WITHOUT TAXES:

i. Ko = KeVe + KdVd
(Ve + Vd) (Ve+Vd)

ii. Keg = Keu + (Keu – Kd)(Vd)

Ve

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 iii. Kog = Kou

iv. Vg = Vu

OTHER THEORIES OF CAPITAL STRUCTURE

The following theories discussed below are also associated with the
capital structure of the firm and its optimality.

PECKING ORDER THEORY

The Pecking Order Theory popularized by Stewart Myers posits
that internal and external funds are used hierarchically. According

to him, businesses adhere to a hierarchy of financing

sources preferring to finance new investment, first internally with

retained earnings, then with debt, and finally with an issue of new
equity.
It maintained that companies prioritize their sources of
financing (from internal financing to equity) according to
the law of least effort, or of least resistance, preferring to
raise equity as a financing means “of last resort”.
Clearly, according to the proponent, equity is a less
preferred means to raise capital.

Trade-Off Theory of Capital Structure

The Trade-Off theory of capital structure was propounded
and popularised by Kraus and Litzenberger. According
to them, optimal capital structure is obtained where the
net tax advantage or benefit of debt financing balances
or equilibrates leverage related costs such as
bankruptcy and agency costs.

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It therefore refers to the idea that a company chooses how
much debt finance and how much equity finance to use by
balancing the costs and be nefits.
Clearly, the theory argued that firms usually are financed
partly with debt and partly with equity. It states that there
is an advantage to financing with debt, the tax
benefits of debt and there is a cost of financing with
debt, the costs of financial distress including bankruptcy
and non-bankruptcy costs (e.g. staff leaving, suppliers
demanding disadvantageous payment terms,
bondholder/stockholder infighting/agency problem, etc).
The marginal benefit of further increases in debt
declines as debt increases, while the marginal cost
increases. Thus a firm that is optimizing its overall value
must focus on this trade-off when choosing how much
debt and equity to use for financing.

Information Asymmetry Theory

The information asymmetry theory of capital structure assumes that
firm managers or insiders possess private information about the
characteristics of the firm’s return stream or investment
opportunities, which is not known to common investors.

REASONS FOR PREFERENCE FOR BORROWING

A number of companies in practice prefer to borrow for the following

reasons including;

i. Tax deductibility of interest (tax advantage)

ii. Higher returns to shareholders due to gearing

iii. Complicated procedure for raising equity capital

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 iv. No dilution of ownership and control

v. Equity results in permanent commitment than debt

OFFSETTING DEMERIT OF DEBT

Several offsetting disadvantages of debt exist in practice. These can
be grouped into the following;

• Personal Taxes (investors pay tax on the interest

gained)

• Financial distress

• Agency problems (conflicts bw DH/SH, SH/MGRS)

PERSONAL TAXES
Personal taxes on interest income reduce the attractiveness of debt.
From the firm’s point of view, there is strong incentive to
borrow, as they will be able to reduce corporate taxes.
However, the advantage of corporate borrowing is reduced by
personal tax loss as investors are required to pay tax on interest.
Thus, the tax saved by the firm is collected in the hands of the
investors.

FINANCIAL DISTRESS
The question to ask here is;
Why do firms tend to avoid very high gearing levels despite
its obvious advantages? One reason is financial distress risk.
Financial distress arises when a firm is not able to meet its
obligations to debt holders. The firm’s continuous failure to make
payments to debt holders can ultimately lead to the insolvency of
the firm.

AGENCY PROBLEMS
Agency costs arise because of the conflict between managers
and shareholders interests, on the one hand, and shareholders

23
and debt holders interests on the other hand. These conflicts give
rise to agency problems, which involves agency costs. The conflict
between shareholders and debt holders arise because of the possibility of
shareholders transferring wealth of debt holders in their favour. Similarly,
the conflict between shareholders and managers arise because
managers may transfer shareholders wealth to their advantage
by increasing their compensation, allowances/ remunerations.
Thus, investors require monitoring and restrictive covenants to
protect their interest.

FACTORS TO CONSIDER IN DETERMINING CAPITAL

STRUCTURE
The determination of capital structure in practice involves additional
considerations. Important amongst these are:
i. Assets
ii. Issue or floatation
iii. Loan covenants
iv. Early repayment
v. Control dilution
vi. Marketability and timing
vii. Capital market conditions
viii. Capacity of raising funds
ix. Tax benefit of Debt
x. Flexibility
xi. Industry Leverage Ratios
(LEVERAGE=DEBT+EQUITY), Fin Leverage reduces
PAT, after paying tax, profit is reduced
xii. Agency Costs

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 xiii. Industry Life Cycle
xiv. Degree of Competition
xv. Company Characteristics
xvi. Requirements of Investors
xvii. Timing of Public Issue
xviii. Legal Requirements

LEVERAGE/GEARING
Leverage can be decomposed into two (2) categories as follows;

• Financial Leverage

• Operating Leverage

FINANCIAL LEVERAGE
The use of fixed charges sources of funds such as debt and
preference capital along with the owner’s equity in the capital
structure is described as financial leverage or gearing or
trading on equity. The main reason for using financial leverage is
to increase the shareholders returns.
The use of the term trading on equity is derived from the
fact that it is the owners’ equity that is used as the basis to
raise debt; i.e. the equity that is traded upon. The supplier of
the debt has limited participation in the company’s profit and
therefore, he will insist on the protection in earnings and protection
in values represented by owner’s equity.
Financial leverage affects PAT or EPS.
Financial leverage is avoidable, if debt is not introduced into the
firm’s capital structure.
OPERATING LEVERAGE
Operating leverage is the responsiveness of the firm’s EBIT to
changes in sales revenue. It arises from the firm’s use of fixed
operating costs. When the fixed operating costs are present in the
company’s capital structure, changes in sales are magnified into

25
greater changes in EBIT. Leverage associated with fixed operating
costs.
Operating leverage affects a firm’s operating profit.

COMBINING FINANCIAL AND OPERATING LEVERAGES

Firms use operating and financial leverage in various degrees. The
combined use of operating and financial leverage can be measured
by computing the degree of combined leverage. These combined
effects of two leverages can be quite significant for the earnings
available to ordinary shareholders.
DEGREE OF OPERATING LEVERAGE
Degree of operating leverage (DOL) is defined as the percentage
change in EBIT relative to a given percentage change in sales. Thus,

DOL = % change in EBIT

% change in sales

The following equation can also be used to compute the degree of

operating leverage (DOL) including;

• DOL = Contribution
EBIT

• DOL = Fixed Cost + 1

EBIT

• DOL = Q( S-V )
Q(S-V) -F

• DOL = VC
EBT

DEGREE OF FINANCIAL LEVERAGE (DFL)

Financial leverage affects the EPS. When the economic conditions
are good and the firm’s EBIT is increasing, its EPS increases faster

26
with more debt in the capital structure. The degree of financial
leverage (DFL) is defined as the % change in EPS due to a
given % change in EBIT. That is;

DFL = % change in EPS

% change in EBIT

DFL can also be expressed in any following ways;

• DFL = EBIT
PBT

• DFL = Q(S - V) – F
Q(S - V) – F- Interest

EFFECT OF COMBINED OPERATING AND FINANCIAL

LEVERAGE
Operating and Financial Leverage together can cause wide
fluctuation in EPS for a given change in sales. If a company employs
a high level of operating and financial leverage, even a small
change in the level of sales will have a dramatic effect on EPS.
The degrees of operating and financial leverages can be combined
to observe the effect of total leverage on EPS associated with a
given change in sales.
This can be expressed as;

DCL = DOL +DFL

DCL = Contribution + EBIT = Contribution

EBIT PBT PBT

DCL = Q(S-V) X Q(S-V) –F = Q(S-V)

Q(S-V)-F Q(S-V)-F-Int Q(S-V)-F-Int

FINANCIAL LEVERAGE AND SHAREHOLDER’S RISK

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It has been documented that financial leverage magnifies
shareholders earnings. Also, it is established that the
variability of EBIT causes EPS to fluctuate within wider
ranges with debt in the capital structure. That is, with
more debt, EPS rises and falls faster than the rise and fall in
EBIT. Thus, Financial Leverage not only magnifies EPS but also
increases its variability.
The variability of EBIT and EPS distinguishes between 2
types of risk i ncluding:-
i. Operating/Business risk
ii. Financial risk

OPERATING/BUSINESS RISK
It is the variability of EBIT associated with a company’s normal
operations. The environment in which a firm operates
determines the variability of EBIT. So long as the environment
is given to the firm, operating risk is an UNAVOIDABLE risk.
Clearly, it arises due to uncertainty of cash flows of the firm’s
investments.
FINANCIAL RISK
Arises on account of the use of debt for financing investments.
A totally equity financed firm will have on financial risks if the
firm decides not to use any debt in its capital structure.

MEASURES OF LEVERAGE/GEARING
The appropriate question to ask here is; ‘How is
Gearing/Leverage measured?’ Clearly, several measures of
leverage exist in the literature including;
i. Income measure
ii. Market value measure

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 iii. Book value measure

INCOME MEASURE
This measure indicates the capacity of the firm to meet fixed
financial charges. Under here, the level of gearing is measured
by the ratio of fixed interest payment to the company’s total
profit. That is;
Gearing = Fixed Interest Payable
Total profit after interest before Tax.

BOOK VALUE MEASURE

Book values are historical figures and when used, may not
reflect current prices. The book value of ordinary shares is the
sum of share capital, Reserves/Retained Earnings and share
premium
Gearing using Book values can be measured as follows:-
Gearing = Book value of fixed interest security
Total Book value of capital (D + E)

MARKET VALUE MEASURE

Market values reflect the current attitude of investors and thus
it is theoretically more appropriate. But it is difficult to get
reliable information on market values in practice. The market
values of securities fluctuate frequently. Market value measure
is expressed as;
Gearing = Market value of fixed interest security
Total market value of capital (D + E)

FACTORS TO CONSIDER IN DECIDING WHETHER TO USE

EQUITY OR DEBT FINANCE.

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In deciding whether to go for equity or debt financing, the
following considerations are important;
a) Dilution of Ownership: If new shares are issued to
new shareholders, it will lead to dilution of control.
Thus if a firm is conscious of retaining control, it can
opt for debt finance.
b) Stability of Earnings: If the company’s earnings are
highly variable, debt finance will increase the
variability and the company’s vulnerability.
c) Security: Issue of debt and the use of debt finance
may require security to be provided by the company.
d) Tax Savings: Interest paid on debt is a tax allowable
expense, giving rise to savings. A firm desirous of this
savings can opt for debt finance.
e) Financial Risk: Borrowing will introduce financial risk
to the company.

TREATMENT OF PREFERENCE SHARES IN GEARING

Preference shares are difficult to classify. It is often considered
to be a hybrid security since it has many features of both
ordinary shares and debentures.
It is similar to ordinary shares in that;
i. The non payment of dividend does not force the company
into liquidation
ii. Dividends are not deductible for tax purposes and
iii. It has no fixed maturity date.
On the other hand, it is similar to debentures because;
• Dividend rate is fixed

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 • Preference shareholders do not share in the residual
earnings
• Preference shareholders have claims on income and
assets prior to ordinary shareholders.
• They usually do not have voting rights.
Thus, there are two (2) ways to the treatment of this
source of finance. Preference shareholders are regarded as
members of the company during liquidation. Therefore, they
receive no payment until all the creditors have been settled. In
this manner, they are treated just like equity shareholders.
But this type of shareholders equally carries the right to a fixed
dividend and do not share in the residual dividend. In this case,
it is sappropriate to classify preference shares as a form of
borrowing.

PRACTISE TEASERS ON CAPITAL STRUCTURE

QUESTION 1
A Limited has an expected annual net operating income of
N5,000,000 with a cost of equity of 10% N800,000 8%
debenture.
REQUIRED:
i. Calculate the value of the firm and the company’s cost
of capital.
ii. Assuming that debenture is increased to N1,000,000
while other items remain the same, will the value of
the firm and cost of capital change?

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 Hint: Assume the Net Income approach.

QUESTION 2
Two firms identical in all respects, one unlevered with N50,000
capital and the other levered with N25,000 10% Debt and
N25,000 equity financing for its operations. Both firms earn
expected return before interest and taxes of N12,500 and will
be liable to pay 30% company tax. The policy of both firms is
to distribute all earnings available and the present value of
interest tax shield for the levered firm.
REQUIRED:
Determine the value of both firms and ascertain the present
value of interest tax shield.

QUESTION 3
A firm has N500,000 perpetual streams of operating incomes
per annum, with the overall capitalization rate of 16%. The firm
is partially financed by debt of N80,000 at 12%
REQUIRED:
i. Calculate the market value of the firm and cost of
equity.
ii. Suppose the debt increased to N1,000,000 while other
items remain constant, will this affect the value of the
firm and cost of equity
Hint: Assume the Net Operating approach.
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 QUESTION 4
Rogers Plc. has a geared capital structure with details as
follows:
= Nm =
Value of Debt 200
Value of Equity 300
Total value 500
Existing cost of debt, before taxes 12.50%
Existing cost of equity 20%
Tax rate 40%
The company proposes to raise N25m of new equity and to use
the money raised to repay N25m of the company’s debt (which
can be assumed to be undated). Assume all earnings are
distributed as either interest or dividend.

REQUIRED:
a) Calculate the existing; (i) WACC (ii) EBIT (iii) Return
required by the ordinary shareholders to compensate
for business risk only.
b) After the change in capital structure, calculate:
i. The company’s total market value
ii. Shareholders wealth
iii. The company’s WACC
iv. The company’s cost of equity.

QUESTION 5

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Dangote Cement Plc and Atlas Cement Company are two
publicly quoted companies in the same business risk class.
Each has a constant annual earnings flow (EBIT) of N5m. This
level of earnings is expected to be maintained by both
companies in the future.
Dangote has issued N8m of 9% undated debentures. The
debentures are currently priced to yield 18% per annum. Atlas
cement has no debt. Each of Dangote cement’s 17.2 million
ordinary shares is currently quoted at N1, ex-div while Atlas
has issued 46.4 million shares each of which has a market
price of N0.50, ex-div. Both companies’ payout the entire
earnings flow each years as dividends and interest.
Foss holds 464,000 shares in Atlas cement as part of her well
diversified investment portfolio. Her market analysis leads her
to believe that Dangote shares are currently under priced
because of a temporary disequilibrium in the market. As a
result, she is considering selling her holdings and investing in
Dangote instead.
REQUIRED:
i) Provide calculations to show that in fact the shares of
Dangote Plc are currently under priced.
ii) Suggest how Foss could undertake Arbitrage deal so
as to maintain her level of financial risk. Explain briefly
why you think your suggested approach will maintain
her financial arise level.
iii) What would be the equilibrium share price of
Dangote’s equity if other investors also undertook
arbitrage deals? Assume that the market prices of the
other securities are in equilibrium.
iv) Explain what is meant by same Business Risk class?
v) What is financial risk and who bears this risk?
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 QUESTION 6
PMS is a private company with intentions of obtaining a stock
market listing in the near future. The company is wholly equity
financed at present but the Directors are considering a new
capital structure prior to it becoming a listed company.
PMS operates in an industry where the average assets beta is
1.2. The company’s business risk is estimated to be similar to
that of the industry as a whole. The current level of earnings
before interest and taxes is N400,000. This earnings level is
expected to be maintained to the future.
The rate of return on riskless assets is at present 10% and the
return on the market portfolio is 15%. These rates are post-tax
and are expected to remain constant for the foreseeable
future.
PMS is considering introducing debt into its capital structure by
one of the following methods;
i) N500,000 10% debentures at par, secured on land and
buildings of the company.
ii) N1,000,000 12% unsecured loan stock at par.
The rate of income tax is expected to remain at 33% and
interest on debt is tax deductible.
REQUIRED:
a) Calculate for each of the options;
i. Total market values of the firm
ii. Value of equity
b) List the main problems and costs which might arise for a
company experiencing a period of severe financial
difficulties.
QUESTION 7

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The Management of CWAY Ltd. had developed the following
income statement based on an expected sales volume of
100,000 units.
Details =N=
Sales (100,000 units @ N8) 800,000
Variable cost (100,000 @ N4) (400,000)
Contribution 400,000
Fixed costs
(280,000)
EBIT 120,000
REQUIRED
Compute DOL

QUESTION 8
The profit and loss Account of Alamco plc for the last financial
year was;
N000 N000
Sales 3,600
Variable costs 1440
Fixed costs 960
(2400)
1,200
Interest on Loan finance (400)
PBT 800
Tax rate @ 30% (240)
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 PAT 560

REQUIRED:
i. Compute the company’s operating leverage?
ii. What is the company’s financial leverage?

QUESTION 9
A, B, and C Plc are 3 companies in the same line of Business.
The abridged Balance sheets of the companies as at 31/12/03
are below:
Details A plc B plc C plc
Assets N000 N000 N000
Fixed Assets 600 500 400
Current Assets 400 500 600
1,000 1,000 1,00
Financed By: 0
Share capital (ord. share of
N1 each 800 600
9% Debentures 200 400 400

37
 1,000 1,000 600
1,00
0

It has been observed that the acceptance of the company’s

product lines is identical and will continue to be so in the
future. For the year 2004, the product line acceptance will
either be HIGH, AVERAGE or LOW. If high, each firm’s
operating income will be N120m. An average product line
acceptance will result in N80m operating income while a low
level acceptance is expected to result in N40m operating
income for each company.
REQUIRED:
a) Assuming a company tax rate of 30%, show the likely
effect of financial leverage on each company’s return
on equity.
b) Comment briefly on the results obtained.

QUESTION 10
AB Ltd needs N1,000,000 for expansion. The expansion is
expected to yield an annual PBIT of N160,000. In choosing a
financial plan, AB Ltd has an objective of maximizing EPS.
It is considering the possibility of issuing equity shares and
raising debt of N100,000 or N400,000 or N600,000. The
current market price per share is N25 and is expected to drop
to N20 if the funds are borrowed in excess of N500,000. Funds
can be borrowed at the rates indicated below;
i. Up to N100,000 @ 8%
ii. Over N100,000 up to N500,000 @ 12%
iii. Over N500,000 @ 18%

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REQUIRED:
Determine the EPS of the 3 financing alternatives and suggest
which financing alternative is the best.

QUESTION 11
The following represents the capital structure of Dangote Plc
as at 31/2/06;
=N=
Ord. shares of N1 each 700,000
Capital Reserves 500,000
Revenue Reserve 800,000
2,000,000
9% Debenture 600,000
15% Debenture 900,000
3,500,000
The current yield on debenture on this risk class is 12%. The
current share price is N5.50k and EPS is N1.10k. The company
is considering an expansion plan which cost N1m and which
will increase earnings by N200,000 per annum for the future
There are 2 possible ways to raise the fund required;
1. An issue of 12% debentures which will increase the
return required by shareholders to 22% to compensate
them for the higher risk due to the increased gearing.
2. An issue of 200,000 new shares of N5 to a consortium
institution. This will reduce the return required by
shareholders to 19% because of reduction in gearing.
REQUIRED:
a) Calculate the capital gearing of the company as at
31/12/06 using the Book value approach.
b) Calculate the gearing of the company using Market value
approach.
39
 c) Explain why the market value approach is more superior.
d) Calculate the capital gearing of the company after the
issue of 1,000,000 debentures using the Market value
approach.
e) Calculate the capital gearing of the company after the
issue of 200,000 ordinary shares using the Market value
approach.
f) Explain how preference shares should be treated in the
calculation of capital gearing.

QUESTION 12
Two companies, Trinidad and Tobago are both in the same
business risk class but with different capital structure. A
summary of their market value and earnings are given below;

TRINIDAD TOBAGO
=N= =N=
Equity 90,000 50,000
Debts - 50,000
90,000 100,000
EBIT 20,000 20,000
Interest - -- (5000)

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Dividend 20,000 15,000

REQUIRED
1. Determine whether or not the two companies are in
equilibrium.
2. An investor holding 5% of the equity of Tobago has
approached you with the following question;
i. Whether he can increase his earnings of the same
investment through arbitrage?
ii. Whether he can hold its earnings constant and
reduce its investment?
Advice him with full details. What conclusions do you
draw?

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