FINMAN

Capital Structure and Leverage
 The Target Capital Structure

 Business and Financial Risk
 Optimal Capital Structure
 Capital structure theory
 Capital Structure Decisions
 Variations in Capital Structure
13-1
I. The Target Capital Structure
Target Capital Structure -the mix of debt,
preferred stock, and common equity the firm
wants to have
If the actual debt ratio is significantly below the target

level, management will raise capital by issuing debt,
whereas if the debt ratio is above the target, equity will
be used.
13-2
I. The Target Capital Structure
Four primary factors influence capital structure
decisions:
1. Business Risk
2. The firm’s tax position
3. Financial flexibility
4. Managerial conservatism or aggressiveness
13-3
II. Business And Financial Risk
1. Business risk, which is the riskiness of the
firm’s assets if no debt is used.
2. Financial risk, which is the additional risk

placed on the common stockholders as a
result of using debt.
13-4
a.) Business Risk
the single most important determinant of capital structure, and
it represents the amount of risk that is inherent in the firm’s
operations even if it uses no debt financing.
13-5
a.) Business Risk
Business risk depends on a number of factors, the more important of
which are listed here:
1. Demand variability. The more stable the demand for a firm’s

products, other things held constant, the lower its business risk.
2. Sales price variability. Firms whose products are sold in highly

volatile markets are exposed to more business risk than similar firms
whose output prices are more stable.
3. Input cost variability. Firms whose input costs are highly uncertain
are exposed to a high degree of business risk.
4. Ability to adjust output prices for changes in input costs. Some firms
are better able than others to raise their own output prices when input
costs rise. The greater the ability to adjust output prices to reflect cost
conditions, the lower the degree of business risk.
13-6
a.) Business Risk
Business risk depends on a number of factors, the more important of
which are listed here:
5. Ability to develop new products in a timely, cost-effective

manner. Firms in high-tech industries such as drugs and computers
depend on a constant stream of new products. The faster a firm’s
products become obsolete, the greater the firm’s business risk.
6. Foreign risk exposure. Firms that generate a high percentage of

their earnings overseas are subject to earnings declines due to
exchange rate fluctuations. Also, if a firm operates in a politically
unstable area, it may be subject to political risk.
7. The extent to which costs are fixed: operating leverage. If a high

percentage of its costs are fixed (and hence do not decline when
demand falls), the firm will be exposed to a relatively high degree
of business risk. This factor is called operating leverage, and it is
discussed at length in the next section.
13-7
b.) Operating Leverage
The extent to which fixed costs are used in a firm’s
operations.
 More operating leverage leads to more
business risk, for then a small sales decline
causes a big profit decline.
$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales
13-8
c.) Financial Risk
the additional risk placed on the common
stockholders as a result of the decision to finance
with debt
13-9
c.) Financial Risk
13-10
III. Determining the Optimal
Capital Structure
Optimal capital structure is the one that

maximizes the price of the firm’s stock,
and this generally calls for a debt ratio
that is lower than the one that maximizes
expected EPS.
13-11
a.) WACC and Capital Structure Changes
Debt ratio: 0% Debt: 0

Assets: 200,000 Equity: 200,000
Shares Outstanding: 10,000 VC: 60,000 FC: 100,000 13-12
b.) The Hamada Equation
Increasing the debt ratio increases the risks that

bondholders face and thus the cost of debt. More debt
also raises the risk borne by stockholders, which raises the
cost of equity, rs.
bL - firm’s current beta

bU - firm’s beta if the firm was debt-free
D/E -measure of financial leverage
T -corporate tax rate
13-13
b.) The Hamada Equation
Unlevered Beta, bU -the firm’s beta

coefficient if it has no debt
13-14
c.) The Optimal Capital Structure
- the capital structure that maximizes a stock’s intrinsic
value.
13-15
c.) The Optimal Capital Structure
13-16
VI. Variations in Capital
Structure
- Capital structure ratios are calculated as a percentage of total capital, where

total capital is defined as long term debt plus equity, with both measured at
book value.
- These ratios are based on accounting (or book) values. Stated on a market-
value basis, the equity percentages would rise because most stocks sell at prices
that are much higher than their book values.
13-17
Thanks!
Deloso
Estano
Hayagan
Villasor
13-18
ACTIVITY
13-19
The riskiness inherent in the firm’s
operation if it uses no debt
BUSINESS RISK
13-20
An increase in stockholder’s risk,
over and above the firm’s basic
business risk, resulting from the
use of financial leverage
FINANCIAL RISK
13-21
The firm’s beta coefficient if it
has no debt
Unlevered Beta
13-22
A capital structure theory that
states the firm’s trade off the tax
benefits of debt financing
against problems caused by
potential bankruptcy
Trade-off Theory
13-23
The situation where investors
and manager have identical
information about firm’s
prospects
Symmetric Information
13-24
13-25
13-26
Julia Barreto
13-27
Gerald Anderson
13-28
ASCENDING 40
13-29

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Capital Structure and Leverage

 The Target Capital Structure

If the actual debt ratio is significantly below the target

2. Financial risk, which is the additional risk

1. Demand variability. The more stable the demand for a firm’s

2. Sales price variability. Firms whose products are sold in highly

5. Ability to develop new products in a timely, cost-effective

6. Foreign risk exposure. Firms that generate a high percentage of

7. The extent to which costs are fixed: operating leverage. If a high

Optimal capital structure is the one that

Debt ratio: 0% Debt: 0

Increasing the debt ratio increases the risks that

bL - firm’s current beta

Unlevered Beta, bU -the firm’s beta

- Capital structure ratios are calculated as a percentage of total capital, where

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