FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory

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Financial Management MGT201

Lesson 32

FINANCIAL LEVERAGE AND CAPITAL STRUCTURE

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following

topics:

· Financial Leverage

· Capital Structure

First we recap some concepts of previous lectures.

· WACC % = rD XD + rE XE + rP XP. (Debt, Common Equity, Preferred Equity)

o Where "r" is ACTUAL COST which can be calculated from REQUIRED ROR after

accounting for Taxes & Transaction Costs.

o Equity Capital: If Not Enough Retained Earnings then Equity Capital must be financed

by New Stock Issuance which is more costly.

· Total Risk Faced by FIRM

= Business Risk + Financial Risk

· Higher Operating Leverage (OL = Fixed Costs / Total Costs)

o Higher Mean ROE WHEN FIRM'S SALES > BREAKEVEN POINT

o Higher Fixed Costs means Higher Breakeven Point and More Chances of Operating

Loss. Risk of Large Drop in Return on Equity (ROE) so Higher Risk.

Financial Risk:

From the discussion of the previous lecture we can infer that

Financial Risk = Total Standalone Risk Business Risk

For example, if

Total risk as measured by standard deviation of ROE of levered firm = 30%

and Business risk as measured by standard deviation of ROE of un-levered firm = 20%

then

Financial Risk = 30% - 20% = 10%

Financial Risk is created when firms take loan or debt. As companies take more debt they are exposed

to more financial risk.

Financial Leverage (FL):

Financial Leverage shows the effect that small increase in EBIT can create much larger increase in ROE

of the firm.

Financial Leverage (%) =Debt /Total Assets = Debt / Debt + Equity

If firm has Rs.1000 of total assets and Rs.500 debt then it has 50% (=500/1000) financial leverage. So

this firm has 50% leverage means 50% equity and 50% debt. Practically, firms increase financial

leverage by

Issuing New Debt (i.e. Taking New Loans and Increase Debt)

Replacing Equity with New Debt ( Increasing debt and increasing equity too)

Financial Leverage Impact on Risk & Return of Firm:

Financial Leverage (or Debt Financing) generally increases overall risk & return of a firm. Let

us have a look now on a table that shows how when a firm becomes levered it increases the variability

of ROE and how it increases the mean ROE.

Effect of Leverage on ROE Volatility & Risk

EBIT

Interest

EBT

Tax

Net Income ROE

(Rs.50)

(30%)

(=NI/Equity)

Un-Levered

600

180

420

42%

Firm with

300

210

21%

no debt or 100%

3.5%

equity

Levered firm

600

550

165

385

77%

with debt

300

250

175

35%

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Financial Management MGT201

This table shows the effect on ROE as earnings change from Rs.50 to Rs.600. This variation in

earnings can be due to market forces or random events. This variation in sales revenue can lead to

change in EBIT and this is source of risk. This will lead to change in possible values of ROE. Results of

the table for levered and un-levered firm indicate that leverage (or Debt) increases the spread or range of

possible ROE thereby increasing uncertainty and risk. Financial Leverage (or Debt Financing) generally

increases overall risk & return of a firm due to the following reasons:

· Increases Return (Mean ROE):

When EBIT /Total Assets > Interest Cost then Financial Leverage is Good. Small Increase

in EBIT can create much larger Increase in ROE. If

EBIT /Total Assets > Interest Cost it means firm is generating profit by the use of its debt

resulting in increased ROE as firm has positive cash flows.

If Equity (and number of shares) reduced then Return (NI) per Share Increases. By reducing

its equity the firm will increase its percentage of debt in capital structure. As the earnings

are the same to be distributed among lesser number of shares due to reduced equity the

return will increase per share resulting in increased ROE.

These two effects can be visualized in the following graph:

Visualizing Financial Leverage (FL)

Impact on ROE & Capital Structure

LEVERED (Debt

ROE (%)

& Equity) Firm:

77%

Higher Slope.

ROE more

sensitive to

changes in EBIT

42%

35% = <ROE>L

UN-LEVERED

(100% Equity)

21% = <ROE>UL

Firm. Safer

Capital Structure

3.5%

at Low EBIT's

EBIT (Rs)

300

600

This is the graphic representation of the above table of Effect of Leverage on ROE Volatility & Risk

for a levered and un levered firm. It indicates that leverage (or Debt) increases the spread or range of

possible ROE thereby increasing uncertainty and risk. Range of possible values of ROE have been

indicated by straight lines while level of risk by the probability distributions.

· Increases Risk (Standard Deviation in ROE):

Fixed Interest Dues so Higher Chances of Losses, No Dividends for Shareholders.

Possibility of Large Drop in ROE. Possibly Default. More Risk Transferred to

Stockholders.

If Equity (and number of shares) reduced then Risk per Share Increases.

This can also be visualized in the following graph:

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Financial Management MGT201

Visualizing Impact of Financial Leverage

on ROE & Capital Structure

Un-Levered (100% Equity):

Lower ROE and Lower Risk.

Levered (Debt & Equity):

Risk

Higher ROE but Higher Risk

Risk

Mean ROE

<ROE>Levered =

<ROE>Un-Levered

= 21%

35%

Return on Equity ( ROE)%

Capital Structure Theory:

From the discussion of Financial leverage we know Financial Leverage (FL = Debt / (Debt +

Equity))

Increases Overall Return (Mean ROE) when EBIT/Total Assets > Interest (or Cost of Debt)

then Leverage is Good because small Increase in EBIT causes much LARGER Increase in ROE.

Increases Overall RISK (Standard Deviation of ROE) of FIRM. Leverage will always

MAGNIFY or AMPLIFY a small change in EBIT into a LARGER change in ROE.

· Fundamental Principle in Risk-Return: Rational Investors in Efficient Markets will only take Extra

Risk if they are compensated by Sufficient Extra Return.

· Should the Management of a Firm undertake Financial Leverage? If so, then how much Debt

should a Firm have?

Answer provided by Capital Structure Theory.

Modigliani - Miller:

· Fathers of Corporate Finance

· "Cost of Capital, Corporate Finance and the Theory of Investment" Revolutionary Article

Published by Professors Modigliani & Miller in American Economic Review in June 1958.

Won Nobel Prize.

· "Pure M-M" (or Modigliani-Miller) Model - IDEAL CASE:

There is no fixed ratio for debt in capital structure. Generally it varies with each company's needs

and requirements. Capital structure theory tries to determine the most suitable ratio for a firm.

Major Assumptions: No Taxes, No Bankruptcy Costs, Efficient Markets, Equal

Information Available to All Investors

Major Conclusions:

· Capital Structure has no affect on value of a FIRM! Capital Structure is

Irrelevant!

· It does NOT matter how a firm finances its operations, how much debt it has

because it has no bearing on a Firm's Overall Value as calculated using NPV!

· Corporate Financing & Capital Structure Decisions have no bearing on

Investment (or Capital Budgeting) Decisions.

· Capital Budgeting can be carried out without knowing the exact Capital

Structure of a Firm - you can assume 100% Equity (Un-levered) Firm.

Keep in view these conclusions of the theory are correct only under the ideal conditions as assumed by

Modigliani-Miller.

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Financial Management MGT201

Modified MM - With Taxes:

In order to apply it in the real world for its use, some other economists made some modifications. In

order to make this theory applicable in the real world and to account for the effects of corporate and

personal taxes on investment decision and on firm, the effect of taxes was included in it.

· Modigliani-Miller (With Corporate Tax)

In most countries, a Firm's Interest Payments to Bond Holders are NOT Taxed. But

Dividend Payments to Equity Holders are taxed.

Based on CORPORATE TAXES, FIRMS should prefer to raise Capital using DEBT

Financing rather than equity as there is saving associated with capital raised through

this source.

From firms point of view interest payments are source of tax savings.

· Merton-Miller (With Personal Tax)

In most countries, INVESTORS (bondholders and shareholders) pay a higher Personal

Income Tax on Interest Income from Bonds than on Dividend Income from Equity (or

Stocks).

Based on PERSONAL TAXES, INVESTORS should prefer to invest in STOCKS (or

Equity).

Uncertain Conclusion: Difficult to determine Net Effect of taxes on optimal capital structure. But,

practically speaking, Corporate Tax Effect is generally stronger so Based on Taxes alone, Firms should

prefer Debt.

We shall discuss other modifications in Modigliani Miller capital structure theory along with the one

discussed above in the next lecture.

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