Faculty of International Business and

Humanities (FIBH)

Financial Management and Control systems

Dr. Ahmed Rady

Assistant Professor of Finance and Investment
Chapter

Capital Structure and Leverage

 Learning Goals

LG1 Discuss leverage, LG3 Describe the types

capital structure, breakeven LG2 Understand of capital, external
analysis, the operating operating, financial, and assessment of capital
breakeven point, and the total leverage and the structure, the capital
effect of changing costs on relationships among them. structure of non-U.S. firms,
the breakeven point. and capital structure theory.

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Learning Goals (cont.)
LG4 Explain the optimal capital structure using a graphical view of the
firm’s cost of capital functions and a zero-growth valuation
model.
LG5 Discuss the EBIT-EPS approach to capital structure.
LG6 Review the return and risk of alternative capital structures, their
linkage to market value, and other important capital structure
considerations related to capital structure.

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Capital Structure
• Capital structure is how a company funds its overall
operations and growth.
• Debt consists of borrowed money that is due back to
the lender, commonly with interest expense.
• Equity consists of ownership rights in the company,
without the need to pay back any investment.

5
Capital Structure
• Capital structure is one of the most complex areas of financial decision
making because of its interrelationship with other financial decision
variables.
• Poor capital structure decisions can result in a high cost of capital,
thereby lowering the NPVs of projects and making more of them
unacceptable.
• Effective capital structure decisions can lower the cost of capital,
resulting in higher NPVs and more acceptable projects—and thereby
increasing the value of the firm.

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The Firm’s Capital Structure:
Types of Capital
All of the items on the right-hand side of the firm’s balance sheet, excluding current
liabilities, are sources of capital. The following simplified balance sheet illustrates
the basic breakdown of total capital into its two components, debt capital and equity
capital.

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 Which source of capital
is lower in your opinion?

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The Firm’s Capital Structure:
Types of Capital (cont.)
• The cost of debt is lower than the cost of other forms of financing.
• Lenders demand relatively lower returns because they take the least
risk of any contributors of long-term capital.
• Lenders have a higher priority of claim against any earnings or assets
available for payment, and they can exert far greater legal pressure
against the company to make payment than can owners of preferred or
common stock.
• The tax deductibility of interest payments also lowers the debt cost to
the firm substantially.

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The Firm’s Capital Structure:
Types of Capital (cont.)
• Unlike debt capital, which the firm must eventually repay, equity
capital remains invested in the firm indefinitely—it has no maturity
date.
• The two basic sources of equity capital are (1) preferred stock
and (2) common stock equity, which includes common stock and
retained earnings.
• Common stock is typically the most expensive form of equity,
followed by retained earnings and then preferred stock.
• Whether the firm borrows very little or a great deal, it is always true
that the claims of common stockholders are riskier than those of
lenders, so the cost of equity always exceeds the cost of debt.
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The Firm’s Capital Structure:
External Assessment of Capital Structure

• A direct measure of the degree of indebtedness is the debt ratio (total liabilities ÷
total assets).
• The higher this ratio is, the greater the relative amount of debt (or financial leverage) in
the firm’s capital structure.
• Measures of the firm’s ability to meet contractual payments associated with debt
include the times interest earned ratio
(EBIT ÷ interest) and the fixed-payment coverage ratio.
• The level of debt (financial leverage) that is acceptable for one industry or line of
business can be highly risky in another, because different industries and lines of
business have different operating characteristics.

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The Firm’s Capital Structure:
External Assessment of Capital Structure
• The fixed-charge coverage ratio (FCCR)
shows how well a company's earnings can
be used to cover its fixed charges such as
rent, utilities, and debt payments.
• Lenders often use the fixed-charge
coverage ratio to assess a company's
overall creditworthiness.
• A high FCCR ratio result indicates that a
company can adequately cover fixed
charges based on its current earnings
alone.

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Table 13.8 Debt Ratios for Selected Industries and Lines of
Business

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Example
Assume that the Loo family is applying for a mortgage loan. The
family’s monthly gross (before-tax) income is $5,380, and they
currently have monthly installment loan obligations that total $560. The
$200,000 mortgage loan they are applying for will require monthly
payments of $1,400.

Mort. pay./Gross income = $1,400/$5,380 = 26%

Tot. instal. pay./Gross income = ($560 + $1,400)/$5,380
= $1,960/$5,380 = 36.4%

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The Firm’s Capital Structure:
Capital Structure of Non-U.S. Firms
In general, non-U.S. companies have much higher degrees of
indebtedness than their U.S. counterparts.
• Most of the reasons relate to the fact that U.S. capital markets are more
developed than those elsewhere and have played a greater role in corporate
financing than has been the case in other countries.

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The Firm’s Capital Structure:
Capital Structure of Non-U.S. Firms
On the other hand, similarities do exist between U.S. corporations and
corporations in other countries.
• First, the same industry patterns of capital structure tend to be found all around
the world.
• Second, the capital structures of the largest U.S.-based multinational
companies, which have access to capital markets around the world, typically
resemble the capital structures of multinational companies from other
countries more than they resemble those of smaller U.S. companies.
• Finally, the worldwide trend is away from reliance on banks for financing and
toward greater reliance on security issuance.

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Matter of Fact
Leverage Around the World
• A recent study of the use of long-term debt in 42 countries found that firms in
Argentina used more long-term debt than firms in any other country.
• Relative to their assets, firms in Argentina used almost 60% more long-term
debt than did U.S. companies.
• Indian firms were heavy users of long-term debt as well. At the other end of
the spectrum, companies from Italy, Greece, and Poland used very little long-
term debt. In those countries, firms used only about 40% as much long-term
debt as did their U.S. counterparts.

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The Firm’s Capital Structure:
Capital Structure Theory
• Research suggests that there is an optimal capital structure range.
• It is not yet possible to provide financial managers with a precise
methodology for determining a firm’s optimal capital structure.
• Nevertheless, financial theory does offer help in understanding how a
firm’s capital structure affects the firm’s value.

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
In 1958, Franco Modigliani and Merton H. Miller (commonly known as
“M and M”) demonstrated algebraically that, assuming perfect markets,
the capital structure that a firm chooses does not affect its value.

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Many researchers, including M and M, have examined the effects of less
restrictive assumptions on the relationship between capital structure and
the firm’s value.
• The result is a theoretical optimal capital structure based on balancing the benefits
and costs of debt financing.
• The major benefit of debt financing is the tax shield, which allows interest payments
to be deducted in calculating taxable income.
• The cost of debt financing results from (1) the increased probability of bankruptcy
caused by debt obligations, (2) the agency costs of the lender’s constraining the firm’s
actions, and (3) the costs associated with managers having more information about
the firm’s prospects than do investors.

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Tax Benefits
• Allowing firms to deduct interest payments on debt when calculating taxable
income reduces the amount of the firm’s earnings paid in taxes, thereby
making more earnings available for bondholders and stockholders.
• The deductibility of interest means the cost of debt, ri, to the firm is subsidized
by the government.
• Letting rd equal the before-tax cost of debt and letting T equal the tax rate,
from Chapter 9, we have ri = rd  (1 – T).

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Probability of Bankruptcy
• The chance that a firm will become bankrupt because of an inability to meet its obligations as
they come due depends largely on its level of both business risk and financial risk.
• Business risk is the risk to the firm of being unable to cover its operating costs.
• In general, the greater the firm’s operating leverage—the use of fixed operating costs—the
higher its business risk.
• Although operating leverage is an important factor affecting business risk, two other factors—
revenue stability and cost stability—also affect it.

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Cooke Company, a soft drink manufacturer, is preparing to make a capital structure
decision. It has obtained estimates of sales and the associated levels of earnings
before interest and taxes (EBIT) from its forecasting group: There is a 25% chance
that sales will total $400,000, a 50% chance that sales will total $600,000, and a
25% chance that sales will total $800,000. Fixed operating costs total $200,000, and
variable operating costs equal 50% of sales. These data are summarized, and the
resulting EBIT calculated, in the following table:

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Table 13.9 Sales and Associated EBIT Calculations for Cooke Company
($000)

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Probability of Bankruptcy
• The firm’s capital structure directly affects its financial risk, which is the risk
to the firm of being unable to cover required financial obligations.
• The penalty for not meeting financial obligations is bankruptcy.
• The more fixed-cost financing—debt (including financial leases) and preferred
stock—a firm has in its capital structure, the greater its financial leverage and
risk.
• The total risk of a firm—business and financial risk combined—determines its
probability of bankruptcy.

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Cooke Company’s current capital structure is as follows:

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Table 13.10 Capital Structures Associated with Alternative Debt Ratios for Cooke
Company
Table 13.11 Level of Debt, Interest Rate, and Dollar Amount of Annual Interest Associated with Cooke
Company’s Alternative Capital Structures

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Table 13.12a Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company

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Table 13.12b Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company

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Table 13.12c Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company

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Table 13.13 Expected EPS, Standard Deviation, and Coefficient of Variation for
Alternative Capital Structures for Cooke Company

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Figure 13.3
Probability Distributions

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Figure 13.4 Expected EPS and Coefficient of
Variation of EPS

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Agency Costs Imposed by Lenders (assignment 1)
• As noted in Chapter 1, the managers of firms typically act as agents of the
owners (stockholders).
• The owners give the managers the authority to manage the firm for the owners’
benefit.
• The agency problem created by this relationship extends not only to the
relationship between owners and managers but also to the relationship between
owners and lenders.
• To avoid this situation, lenders impose certain monitoring techniques on
borrowers, who as a result incur agency costs.

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Asymmetric Information (assignment 1)
• Asymmetric information is the situation in which managers of a firm have
more information about operations and future prospects than do investors.
• A pecking order is a hierarchy of financing that begins with retained earnings,
which is followed by debt financing and finally external equity financing.
• A signal is a financing action by management that is believed to reflect its
view of the firm’s stock value; generally, debt financing is viewed as a positive
signal that management believes the stock is “undervalued,” and a stock issue
is viewed as a negative signal that management believes the stock is
“overvalued.”

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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
What, then, is the optimal capital structure, even if it exists (so far) only in theory?
• Because the value of a firm equals the present value of its future cash flows, it follows that the
value of the firm is maximized when the cost of capital is minimized.

where

EBIT = earnings before interest and taxes

T = tax rate
NOPAT = net operating profits after taxes, which is the after-tax operating
earnings available to the debt and equity holders, EBIT  (1 – T)
ra = weighted average cost of capital
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Figure 13.5
Cost Functions and Value

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EBIT-EPS Approach to Capital Structure
The EBIT–EPS approach is an approach for selecting the capital
structure that maximizes earnings per share (EPS) over the expected
range of earnings before interest and taxes (EBIT).

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EBIT-EPS Approach to Capital Structure (cont.)
We can plot coordinates on the EBIT–EPS graph 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 in Table 13.12. For EBIT
values of $100,000 and $200,000, the associated EPS values calculated
there are summarized in the table below the graph in Figure 13.6.

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Figure 13.6
EBIT–EPS Approach

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EBIT-EPS Approach to Capital Structure: Considering Risk in EBIT-EPS
Analysis

• When interpreting EBIT–EPS analysis, it is important to consider the risk of

each capital structure alternative.
• Graphically, the risk of each capital structure can be viewed in light of two
measures:
1. the financial breakeven point (EBIT-axis intercept)
2. the degree of financial leverage reflected in the slope of the capital structure line: The
higher the financial breakeven point and the steeper the slope of the capital structure line,
the greater the financial risk.

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EBIT-EPS Approach to Capital Structure: Basic Shortcoming of EBIT-EPS
Analysis

• The most important point to recognize when using EBIT–EPS analysis is that this
technique tends to concentrate on maximizing earnings rather than maximizing
owner wealth as reflected in the firm’s stock price.
• The use of an EPS-maximizing approach generally ignores risk.
• Because risk premiums increase with increases in financial leverage, the
maximization of EPS does not ensure owner wealth maximization.

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Choosing the Optimal Capital Structure:
Linkage
• To determine the firm’s value under alternative capital structures, the firm must
find the level of return that it must earn to compensate owners for the risk being
incurred.
• The required return associated with a given level of financial risk can be estimated
in a number of ways.
• Theoretically, the preferred approach would be first to estimate the beta associated with each
alternative capital structure and then to use the CAPM framework to calculate the required
return, rs.
• A more operational approach involves linking the financial risk associated with each capital
structure alternative directly to the required return.

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Table 13.14 Required Returns for Cooke Company’s Alternative Capital Structures

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Choosing the Optimal Capital Structure:
Estimating Value
• The value of the firm associated with alternative capital structures can be
estimated by using one of the standard valuation models, such as the zero-growth
model.

• Although some relationship exists between expected profit and value, there is no
reason to believe that profit-maximizing strategies necessarily result in wealth
maximization.
• It is therefore the wealth of the owners as reflected in the estimated share value
that should serve as the criterion for selecting the best capital structure.

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Table 13.15 Calculation of Share Value Estimates Associated with Alternative Capital
Structures for Cooke Company

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Figure 13.7 Estimated share value and EPS for alternative capital structures for Cooke
Company

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Table 13.16a Important Factors to Consider in Making Capital Structure Decisions

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Table 13.16b Important Factors to Consider in Making Capital Structure Decisions

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