Leverage and Capital Structure

Leverage
and Capital
Structure
Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Leverage Strategy
• Leverage is an investment strategy of using borrowed money —

specifically, the use of various financial instruments or borrowed
capital — to increase the potential return of an investment.
Leverage can also refer to the amount of debt a firm uses to
finance assets
• The ability to influence a system, or an environment, in a way
that multiplies the outcome of one's efforts without a
corresponding increase in the consumption of resources. In other
words, leverage is the advantageous condition of having a
relatively small amount of cost yield a relatively high level of
returns
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-2

Leverage Strategy
• Leverage refers to the use of debt (borrowed funds) to amplify

returns from an investment or project.
• Investors use leverage to multiply their buying power in the
market.
• Companies use leverage to finance their assets: instead of issuing
stock to raise capital, companies can use debt to invest in
business operations in an attempt to increase shareholder value.

Leverage
• Leverage results from the use of fixed-cost assets or funds to

magnify returns to the firm’s owners.
• Generally, increases in leverage result in increases in risk and
return, whereas decreases in leverage result in decreases in risk
and return.
• The amount of leverage in the firm’s capital structure—the mix
of debt and equity—can significantly affect its value by affecting
risk and return.

Leverage (cont.)
Table 12.1 General Income Statement Format and Types

of Leverage

Breakeven Analysis
• Breakeven (cost-volume-profit) analysis is used to:

– determine the level of operations necessary to cover all
operating costs, and
– evaluate the profitability associated with various levels of
sales.
• The firm’s operating breakeven point (OBP) is the
level of sales necessary to cover all operating expenses.
• At the OBP, operating profit (EBIT) is equal to zero.

Breakeven Analysis (cont.)
• To calculate the OBP, cost of goods sold and operating expenses

must be categorized as fixed or variable.
• Variable costs vary directly with the level of sales and are a
function of volume, not time.
• Examples would include direct labor and shipping.
• Fixed costs are a function of time and do not vary with sales
volume.
• Examples would include rent and fixed overhead.

Breakeven Analysis:
Algebraic Approach
Using the following variables, the operating portion

of a firm’s income statement may be recast as
follows:
P = sales price per unit
Q = sales quantity in units
FC = fixed operating costs per period
VC = variable operating costs per unit
• Letting EBIT = 0 and solving for Q, we get:

EBIT = (P x Q) - FC - (VC x Q)

Breakeven Analysis:
Algebraic Approach (cont.)

Breakeven Analysis:
Table 12.2 Operating Leverage, Costs, and Breakeven

Analysis

Breakeven Analysis:
Example: Cheryl’s Posters has fixed operating

costs of $2,500, a sales price of $10 per
poster, and variable costs of $5 per poster.
Find the OBP.
Q = $2,500 = 500 posters

$10 - $5
• This implies that if Cheryl’s sells exactly 500
posters, its revenues will just equal its costs
(EBIT = $0).
Breakeven Analysis:
• We can check to verify that this is the case by

substituting as follows:
EBIT = (P x Q) - FC - (VC x Q)
EBIT = ($10 x 500) - $2,500 - ($5 x 500)
EBIT = $5,000 - $2,500 - $2,500 = $0

Breakeven Analysis:
Graphical Approach
Figure 12.1 Breakeven Analysis

Breakeven Analysis: Changing Costs
and the Operating Breakeven Point
Assume that Cheryl’s Posters wishes to evaluate the impact

of several options: (1) increasing fixed operating costs to
$3,000, (2) increasing the sale price per unit to $12.50, (3)
increasing the variable operating cost per unit to $7.50, and
(4) simultaneously implementing all three of these changes.

(1) Operating BE point = $3,000/($10-$5) = 600 units
(2) Operating BE point = $2,500/($12.50-$5) = 333 units
(3) Operating BE point = $2,500/($10-$7.50) = 1,000 units
(4) Operating BE point = $3,000/($12.50-$7.50) = 600 units

Table 12.3 Sensitivity of Operating Breakeven Point

to Increases in Key Breakeven Variables

Operating Leverage
Figure 12.2
Operating
Leverage

Operating Leverage (cont.)
Table 12.4 The EBIT for Various Sales Levels

Operating Leverage: Measuring the
Degree of Operating Leverage
• The degree of operating leverage (DOL) measures the

sensitivity of changes in EBIT to changes in Sales.
• A company’s DOL can be calculated in two different
ways: One calculation will give you a point estimate,
the other will yield an interval estimate of DOL.
• Only companies that use fixed costs
in the production process will experience operating
leverage.

Degree of Operating Leverage (cont)
DOL = Percentage change in EBIT

Percentage change in Sales
• Applying this equation to cases 1 and 2 in Table
12.4 yields:
Case 1: DOL = (+100% ÷ +50%) = 2.0
Case 2: DOL = (-100% ÷ -50%) = 2.0

Degree of Operating Leverage (cont)
• A more direct formula for calculating DOL at a base

sales level, Q, is shown below.
DOL at base Sales level Q = Q X (P – VC)

Q X (P – VC) – FC
Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500

yields the following result:
DOL at 1,000 units = 1,000 X ($10 - $5) = 2.0

1,000 X ($10 - $5) - $2,500

Operating Leverage: Fixed Costs
and Operating Leverage
Assume that Cheryl’s Posters exchanges a portion of its

variable operating costs for fixed operating costs by
eliminating sales commissions and increasing sales
salaries. This exchange results in a reduction in variable
costs per unit from $5.00 to $4.50 and an increase in
fixed operating costs from $2,500 to $3,000
DOL at 1,000 units = 1,000 X ($10 - $4.50) = 2.2

1,000 X ($10 - $4.50) - $3,000

Operating Leverage: Fixed Costs
and Operating Leverage (cont.)
Table 12.5 Operating Leverage and Increased Fixed Costs

Financial Leverage
• Financial leverage results from the presence of fixed

financial costs in the firm’s income stream.
• Financial leverage can therefore be defined as the
potential use of fixed financial costs to magnify the
effects of changes in EBIT on the firm’s EPS.
• The two fixed financial costs most commonly found on
the firm’s income statement are (1) interest on debt and
(2) preferred stock dividends.

Financial Leverage (cont.)
Chen Foods, a small Oriental food company, expects EBIT of

$10,000 in the current year. It has a $20,000 bond with a
10% annual coupon rate and an issue of 600 shares of $4
annual dividend preferred stock. It also has 1,000 share of
common stock outstanding.
The annual interest on the bond issue is $2,000 (10% x

$20,000). The annual dividends on the preferred stock are
$2,400 ($4/share x 600 shares).
Financial Leverage (cont.)
Table 12.6 The EPS for Various EBIT Levelsa

Financial Leverage: Measuring the
Degree of Financial Leverage
• The degree of financial leverage (DFL) measures the

sensitivity of changes in EPS to changes in EBIT.
• Like the DOL, DFL can be calculated in two different
ways: One calculation will give you a point estimate,
the other will yield an interval estimate of DFL.
• Only companies that use debt or other forms of fixed
cost financing (like preferred stock) will experience
financial leverage.

Degree of Financial Leverage (cont)
DFL = Percentage change in EPS

Percentage change in EBIT
• Applying this equation to cases 1 and 2 in Table

12.6 yields:
Case 1: DFL = (+100% ÷ +40%) = 2.5
Case 2: DFL = (-100% ÷ -40%) = 2.5

Degree of Financial Leverage (cont)
• A more direct formula for calculating DFL at a base

level of EBIT is shown below.
DFL at base level EBIT = EBIT
EBIT – I – [PD x 1/(1-T)]
Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and

the tax rate, T = 40% yields the following result:
DFL at $10,000 EBIT = $10,000

$10,000 – $2.000 – [$2,400 x 1/(1-.4)]
DFL at $10,000 EBIT = 2.5

Total Leverage
• Total leverage results from the combined effect

of using fixed costs, both operating and
financial, to magnify the effect of changes in
sales on the firm’s earnings per share.
• Total leverage can therefore be viewed as the
total impact of the fixed costs in the firm’s
operating and financial structure.

Total Leverage (cont.)
Cables Inc., a computer cable manufacturer, expects sales of

20,000 units at $5 per unit in the coming year and must meet
the following obligations: variable operating costs of $2 per
unit, fixed operating costs of $10,000, interest of $20,000,
and preferred stock dividends of $12,000. The firm is in the
40% tax bracket and has 5,000 shares of common stock
outstanding. Table 12.7 on the following slide summarizes
these figures.

Total Leverage: Measuring the
Degree of Total Leverage
DTL = Percentage change in EPS

Percentage change in Sales
• Applying this equation to the data Table 12.7

yields:
Degree of Total Leverage (DTL) = (300% ÷ 50%) = 6.0

Total Leverage: Measuring the
Degree of Total Leverage (cont.)
• A more direct formula for calculating DTL at a base

level of Sales, Q, is shown below.
DTL at base sales level = Q x (P – VC)
Q x (P – VC) – FC – I – [PD x 1/(1-T)]
Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I =

$20,000, PD = $12,000, and the tax rate, T = 40% yields the
following result:
DTL at 20,000 units = 20,000 X ($5 – $2)

20,000 X ($5 – $2) – $10,000 – $20,000 – [$12,000 x 1/(1-.4)]
DTL at 20,000 units = $60,000/$10,000 = 6.0

Total Leverage: The Relationship of Operating,
Financial and Total Leverage
The relationship between the DTL, DOL, and DFL is illustrated

in the following equation:
DTL = DOL x DFL
Applying this to our previous example we get:
DTL = 1.2 X 5.0 = 6.0

Total Leverage (cont.)
Table 12.7 The Total Leverage Effect

The Firm’s Capital Structure
• Capital structure is one of the most complex areas of

financial decision making due to its interrelationship
with other financial decision variables.
• Poor capital structure decisions can result in a high cost
of capital, thereby lowering project NPVs and making
them more unacceptable.
• Effective decisions can lower the cost of capital,
resulting in higher NPVs and more acceptable projects,
thereby increasing the value of the firm.

Types of Capital

External Assessment of Capital Structure
Table 12.8 Debt Ratios for Selected Industries and Lines of Business
(Fiscal Years Ended 4/1/05 through 3/31/06)

Capital Structure of Non-U.S. Firms
• In recent years, researchers have focused attention not

only on the capital structures of U.S. firms, but on the
capital structures of foreign firms as well.
• In general, non-U.S. companies have much higher
degrees of indebtedness than their U.S. counterparts.
• In most European and Pacific Rim countries, large
commercial banks are more actively involved in the
financing of corporate activity than has been true in the
U.S.

Capital Structure
of Non-U.S. Firms (cont.)
• Furthermore, banks in these countries are permitted to make

large equity investments in non-financial corporations—a
practice forbidden in the U.S.
• However, similarities also exist between U.S. firms and their
foreign counterparts.
• For example, the same industry patterns of capital structure tend
to be found around the world.
• In addition, the capital structures of U.S.-based MNCs tend to be
similar to those of foreign-based MNCs.

Capital Structure Theory
• According to finance theory, firms possess a target

capital structure that will minimize its cost of capital.
• Unfortunately, theory can not yet provide financial
mangers with a specific methodology to help them
determine what their firm’s optimal capital structure
might be.
• Theoretically, however, a firm’s optimal capital
structure will just balance the benefits of debt financing
against its costs.

Capital Structure Theory (cont.)
• The major benefit of debt financing is the tax shield

provided by the federal government regarding interest
payments.
• The costs of debt financing result from:
– the increased probability of bankruptcy caused by debt
obligations,
– the agency costs resulting from lenders monitoring the firm’s
actions, and
– the costs associated with the firm’s managers having more
information about the firm’s prospects than do investors
(asymmetric information).
Capital Structure Theory:
Tax Benefits
• Allowing companies to deduct interest payments when

computing taxable income lowers the amount of
corporate taxes.
• This in turn increases firm cash flows and makes more
cash available to investors.
• In essence, the government is subsidizing the cost of
debt financing relative to equity financing.

Probability of Bankruptcy
• The probability that debt obligations will lead to

bankruptcy depends on the level of a company’s
business risk and financial risk.
• Business risk is the risk to the firm of being unable to
cover operating costs.
• In general, the higher the firm’s fixed costs relative to
variable costs, the greater the firm’s operating leverage
and business risk.
• Business risk is also affected by revenue and cost
stability.

Probability of Bankruptcy (cont.)
• The firm’s capital structure—the mix between debt

versus equity—directly impacts financial leverage.
• Financial leverage measures the extent to which a firm
employs fixed cost financing sources such as debt and
preferred stock.
• The greater a firm’s financial leverage, the greater will
be its financial risk—the risk of being unable to meet
its fixed interest and preferred stock dividends.

• Business Risk
Cooke Company, a soft drink manufacturer, is
preparing to make a capital structure decision. It
has obtained estimates of sales and EBIT from its
forecasting group as show in Table 12.9.
Table 12.9 Sales and Associated EBIT Calculations for Cooke Company ($000)

• Business Risk
When developing the firm’s capital structure, the
financial manager must accept as given these levels
of EBIT and their associated probabilities. These
EBIT data effectively reflect a certain level of business
risk that captures the firm’s operating leverage, sales
revenue variability, and cost predictability.

• Financial Risk
Let us assume that (1) the firm has no current liabilities,

(2) its capital structure currently contains all equity, and
(3) the total amount of capital remains constant at
$500,000, the mix of debt and equity associated with
various debt ratios would be as shown in Table 12.10.
• Financial Risk
Table 12.10
Capital Structures
Associated with
Alternative Debt
Ratios for Cooke
Company

• Financial Risk
Table 12.11
Level of Debt,
Interest Rate, and
Dollar Amount of
Annual Interest
Associated with
Cooke
Company’s
Alternative
Capital Structures

• Financial Risk
Table 12.12
Calculation of
EPS for
Selected Debt
Ratios ($000)
for Cooke
Company (cont.)

• Financial Risk
Table 12.12
Calculation of
EPS for
Selected Debt
Ratios ($000)
for Cooke
Company (cont.)

• Financial Risk
Table 12.12
Calculation of
EPS for
Selected Debt
Ratios ($000)
for Cooke
Company

• Financial Risk
Table 12.13
Expected EPS,
Standard
Deviation, and
Coefficient of
Variation for
Alternative Capital
Structures for
Cooke Company

• Financial Risk
Figure 12.3
Probability
Distributions

• Financial Risk
Figure 12.4 Expected EPS and Coefficient of Variation
of EPS

Capital Structure Theory: Agency Costs
Imposed by Lenders
• When a firm borrows funds by issuing debt, the interest

rate charged by lenders is based on the lender’s
assessment of the risk of the firm’s investments.
• After obtaining the loan, the firm’s stockholders and/or
managers could use the funds to invest in riskier assets.
• If these high risk investments pay off, the stockholders
benefit but the firm’s bondholders are locked in and are
unable to share in this success.

Capital Structure Theory: Agency Costs
Imposed by Lenders (cont.)
• To avoid this, lenders impose various monitoring

costs on the firm.
• Examples would of these monitoring
costs would:
– include raising the rate on future debt issues,
– denying future loan requests,
– imposing restrictive bond provisions.

Asymmetric Information
• Asymmetric information results when managers of a

firm have more information about operations and future
prospects than do investors.
• Asymmetric information can impact the firm’s capital
structure as follows:
Suppose management has identified an extremely lucrative

investment opportunity and needs to raise capital. Based on
this opportunity, management believes its stock is
undervalued since the investors have no information about
the investment.
Asymmetric Information (cont.)

In this case, management will raise the funds using debt

since they believe/know the stock is undervalued
(underpriced) given this information. In this case, the use of
debt is viewed as a positive signal to investors regarding the
firm’s prospects.
Asymmetric Information (cont.)

On the other hand, if the outlook for the firm is poor,

management will issue equity instead since they
believe/know that the price of the firm’s stock is overvalued
(overpriced). Issuing equity is therefore generally thought of
as a “negative” signal.
The Optimal Capital Structure
• In general, it is believed that the market value of a company is

maximized when the cost of capital (the firm’s discount rate) is
minimized.
• The value of the firm can be defined algebraically as follows:

The Optimal Capital Structure
Figure 12.5
Cost Functions
and Value

EPS-EBIT Approach
to Capital Structure
• The EPS-EBIT approach to capital structure involves selecting

the capital structure that maximizes EPS over the expected range
of EBIT.
• Using this approach, the emphasis is on maximizing the owners
returns (EPS).
• A major shortcoming of this approach is the fact that earnings are
only one of the determinants of shareholder wealth
maximization.
• This method does not explicitly consider the impact of risk.

EPS-EBIT Approach
to Capital Structure (cont.)
Example
EBIT-EPS coordinates can be found by assuming specific

EBIT values and calculating the EPS associated with them.
Such calculations for three capital structures—debt ratios of
0%, 30%, and 60%—for Cooke Company were presented
earlier in Table 12.2. For EBIT values of $100,000 and
$200,000, the associated EPS values calculated are
summarized in the table with Figure 12.6.

EPS-EBIT Approach
to Capital Structure (cont.)
Figure 12.6
EBIT–EPS
Approach

Basic Shortcoming
of EPS-EBIT Analysis
• Although EPS maximization is generally good for the

firm’s shareholders, the basic shortcoming of this
method is that it does not necessary maximize
shareholder wealth because it fails to consider risk.
• If shareholders did not require risk premiums
(additional return) as the firm increased its use of debt,
a strategy focusing on EPS maximization would work.
• Unfortunately, this is not the case.

Choosing the Optimal Capital Structure
• The following discussion will attempt to create a

framework for making capital budgeting decisions that
maximizes shareholder wealth—i.e., considers both risk
and return.
• Perhaps the best way to demonstrate this is through the
following example:
Cooke Company, using as risk measures the
coefficients of variation of EPS associated with each
of seven alternative capital structures, estimated the
associated returns as shown in Table 12.14
Choosing the Optimal
Capital Structure (cont.)
Table 12.14 Required Returns for Cooke Company’s

Alternative Capital Structures

By substituting the level of EPS and the associated

required return into Equation 12.12, we can
estimate the per share value of the firm, P0.

Table 12.15 Calculation of Share Value Estimates

Associated with Alternative Capital Structures for Cooke
Company

Figure 12.7
Estimating Value

Table 12.16 Important Factors to Consider
in Making Capital Structure Decisions

Leverage and Capital Structure

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Leverage

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

• Leverage is an investment strategy of using borrowed money —

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-2

• Leverage refers to the use of debt (borrowed funds) to amplify

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-3

• Leverage results from the use of fixed-cost assets or funds to

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-4

Table 12.1 General Income Statement Format and Types

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-5

• Breakeven (cost-volume-profit) analysis is used to:

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-6

• To calculate the OBP, cost of goods sold and operating expenses

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-7

Using the following variables, the operating portion

• Letting EBIT = 0 and solving for Q, we get:

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-8

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-9

Table 12.2 Operating Leverage, Costs, and Breakeven

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-10

Example: Cheryl’s Posters has fixed operating

Q = $2,500 = 500 posters

• We can check to verify that this is the case by

EBIT = ($10 x 500) - $2,500 - ($5 x 500)

EBIT = $5,000 - $2,500 - $2,500 = $0

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-12

Figure 12.1 Breakeven Analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-13

Assume that Cheryl’s Posters wishes to evaluate the impact

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-14

(1) Operating BE point = $3,000/($10-$5) = 600 units

(2) Operating BE point = $2,500/($12.50-$5) = 333 units

(3) Operating BE point = $2,500/($10-$7.50) = 1,000 units

(4) Operating BE point = $3,000/($12.50-$7.50) = 600 units

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-15

Table 12.3 Sensitivity of Operating Breakeven Point

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-16

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-17

Table 12.4 The EBIT for Various Sales Levels

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-18

• The degree of operating leverage (DOL) measures the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-19

DOL = Percentage change in EBIT

Case 2: DOL = (-100% ÷ -50%) = 2.0

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-20

• A more direct formula for calculating DOL at a base

DOL at base Sales level Q = Q X (P – VC)

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500

DOL at 1,000 units = 1,000 X ($10 - $5) = 2.0

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-21

Assume that Cheryl’s Posters exchanges a portion of its

DOL at 1,000 units = 1,000 X ($10 - $4.50) = 2.2

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-22

Table 12.5 Operating Leverage and Increased Fixed Costs

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-23

• Financial leverage results from the presence of fixed

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-24

Chen Foods, a small Oriental food company, expects EBIT of

The annual interest on the bond issue is $2,000 (10% x