Financial Management II Takele Fufa, Ph.

Chapter One
Capital Structure Policy and Leverage.

1.1 The concept of Capital Structure and the Capital structure

question.
It is a question of how should a firm go about choosing its debt/equity ratio. Is there an
optimum capital structure that maximizes firm’s value? Capital structure and cost of
capital relationships. The value of the firm is maximized when the WACC is minimized.
WACC is the discount rate that is appropriate for the firm’s overall cash flows and values
and discount rate move in opposite directions, minimizing the WACC will maximize the
value of the firm’s cash flows.
1.2 FACTORS AFFECTING THE CHOICE OF CAPITAL STRUCTURE
1. Cash Flow Position: Size of projected cash flows must be considered before
issuing debt.
2. Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number
of times earnings before interest and taxes of a company covers the interest
obligation.
3. Debt Service Coverage Ratio(DSCR): Debt Service Coverage Ratio takes care of
the deficiencies referred to in the Interest Coverage Ratio (ICR).
4. Return on Investment (ROI): If the ROI of the company is higher, it can choose
to use trading on equity to increase its EPS, i.e., its ability to use debt is greater.
5. Cost of debt: A firm’s ability to borrow at a lower rate increases its capacity to
employ higher debt. Thus, more debt can be used if debt can be raised at a lower
rate.
6. Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax
rate.
7. Cost of Equity: Stock owners expect a rate of return from the equity which is
commensurate with the risk they are assuming. When a company increases debt,
the financial risk faced by the equity holders, increases.
8. Floatation Costs: Process of raising resources also involves some cost. Public
issue of shares and debentures requires considerable expenditure. Getting a loan
from a financial institution may not cost so much.
9. Risk Consideration: As discussed earlier, use of debt increases the financial risk
of a business.
10. Flexibility: If a firm uses its debt potential to the full, it loses flexibility to issue
further debt.
11. Control: Debt normally does not cause a dilution of control.
12. Regulatory Framework: Every company operates within a regulatory framework
provided by the law e.g., public issue of shares and debentures has to be made
under SEBI guidelines.
13. Stock market conditions: If the stock markets are bullish, equity shares are more
easily sold even at a higher price. However, during a bearish phase, a company
may find raising of equity capital more difficult and it may opt for debt.
14. Capital Structure of other companies: A useful guideline in the capital structure
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planning is the debt-equity rations of other companies in the same industry. There
are usually some industry norms which may help and etc

1.3 Business and Financial risk

Business risk is defined as the equity risk that comes from the nature of the firm’s
operating activities. Business risk depends on the systematic risk of the firm’s asset. The
greater a firm’s business risk, all other things the same, the greater will be its cost of
equity.

There are two kinds of leverage in finance: operating leverage and financial leverage

➢ Leverage measures the relationship between two variables where by a

change in one variable i.e., independent variable results in a change in
another variable (dependent variable).
➢ It measures the behavior of interrelated variables, such as units sold, sales
revenue, EBIT and earning per share.
➢ In finance, LEVERAGE is used to describe the ability of FIXED COST (i.e., both fixed
operating costs and fixed financing costs) to magnify returns to owners.
➢ Fixed expenses over the accounting period are rents, utilities, and some salary & maintenance
expenses.
➢ Costs tend to vary with the level of outputs are cost of purchases & wages.
➢ Costs have both fixed & variable components are overtime payroll expenses & additional repair
& maintenance costs may be incurred when the level of production approaches plant capacity
➢ Fixed financing costs are interest expense & preferred stock dividends. Although interest must
be paid when due, the payment of preferred stock dividends is not legal requirement.

Operating leverage.
Operating leverage refers to magnifying gains and losses in earnings before interest and
taxes (EBIT) by changes that occur in sales. This magnification occurs because in
employing assets the firm incurs certain fixed costs, costs unrelated to the sales volume
created by the assets. Operating costs can be divided into variable and fixed costs. As
sales changes, variable costs change proportionally. This means the variable cost ratio to
sales is constant. This is true over some relevant range of sales. Variable cost includes
material, direct labor, repair and maintenance expenses. Fixed operating costs are
independent of sales level in the short run and over the relevant sales range. In the long
run all costs are variable. Fixed costs include depreciation, indirect labor cost, overhead
costs.

Degree of Operating Leverage (DOL)

Degree of operating leverage is computed as:

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DOL= %ΔEBIT
%Output where, EBIT is earning before interest and tax
Or
=1+ F
EBIT where, F is fixed operating cost
Or
DOL at base sales level Q = Q (P-V)
Q (P-V)-F where, Q is quantity, P is price,
V is variable cost and F is fixed cost

Example,
P= 10 birr
V= 4 birr
F= 30,000 birr
Level of out put (Q) is 8,000 and increase to 10,000 units.

Required:
Determine DOL?

Solution:

EBIT= Q (P-V)-F
=8000(10-4)-30,000 = 18,000
EBIT= 10,000(10-4)-30,000=30,000
Percentage change in EBIT= (30,000-18,000)/18,000=66.67%
Percentage change in out puts = (10,000-8,000)/8,000=25%
DOL= %ΔEBIT
%Output
66.67%/25%=2.67
or
1+ F
EBIT
1+ 30,000/18,000=2.67
or
= Q(P-V)
Q(P-V)-F
=8,000(10-4)
8,000(10-4)-30,000
=2.67

The coefficient of operating leverage of 2.67 is interpreted as a 1% change in output from

the current base levels, there will be a 2.67% change in EBIT in the same direction as the
out put (sales) change. If out put (sales) increase by 10%, EBIT will increase by 26.7%
(10x 2.67%). Similarly, if out put (sales) decrease by 10%, EBIT will decrease by 26.7%.
Other things equal, the higher the fixed costs relative to variable costs, the higher the
operating leverage.

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Example,

AA firm has a base level of 150,000 units of sales. The sales price per unit is $10.00 and
variable costs per unit are $6.50. Total annual operating fixed costs are $155,000, and the
annual interest expense is $90,000. What is this firm’s degree of operating leverage
(DOL)?

Solution

DOL = Q(P-V) = 150,000(10-6.50)

Q(P-V)-F 150,000(10-6.50)-150,000
=1.4

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Breakeven analysis:
The sales level that corresponds with a zero EBIT level is called the break-even sales
level.

EBIT= SALES- VARIABLE COST- FIXED COST

0 =P.Q-V.Q-FC
0 = Q(P-V)-FC
Q(P-V) = FC
Q = FC
P-V
Example,
P = 10
V=4
FC = 90,000
Required: Determine operating break even in units and sales?
Q = FC
P-V
= 90,000/(10-4) = 15,000 units. Sales = 10x 15,000 =150,000
Note that the coefficient of operating leverage at operating break even has undefined
value.
Example,
Compute EBIT and coefficient of operating leverage when Q is 10,000 units?
Solution:
EBIT= Q(P-V)-F = 10,000 (10-4)- 90,000= (30,000)
DOL = Q(P-V) = 10,000(10-4)
Q(P-V)-F 10,000(10-4)-90,000
=2
or
DOL =1+ F = 1 + 90,000
EBIT (30,000)
1-3= 2

Note: -Technically, the formula for DOL should include absolute value signs because it is
possible to get a negative DOL when the EBIT for the base sales level is negative. Since
we assume that the EBIT for the base level of sales is positive, the absolute value signs
are not included.

- Because the concept of leverage is linear, positive and negative changes of equal
magnitude

Break even analysis limitation:

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1. There is a narrow range of sales over which expects fixed costs to be actually
fixed.
2. It is only helpful when there is linear relationship among variable, EBIT and
sales.

1.4 Financial risk and financial Leverage

Operating leverage refers to the fact that a lower ratio of variable cost per unit to price
per unit causes profit to vary more with a change in the level of output than it would if
this ratio was higher. Financial leverage refers to the fact that a higher ratio of debt to
equity causes profitability to vary more when earnings on assets changes than it would if
this ratio was lower. Obviously, the profits of a business with a high degree of both kinds
of leverage vary more, everything else remaining the same, than do those of businesses
with less operating and financial leverage. Greater variability of profits, of course, means
risk is higher. Therefore, in deciding what the optimum level of leverage is, what is an
acceptable risk/return tradeoff must be determined

Financial leverage is created by financing with sources of capital that have fixed costs.
The major sources of fixed charges financing are debt (requiring interest payment) and
preferred stock require dividend payment and leases which require lease payments. These
financing fixed costs affect the firm’s earning per share (EPS) in the same way that
operating fixed costs affect EBIT. The more fixed charge financing the firm uses, the
more financial leverage it will have.

Degree of Financial leverage:

Degree of financial leverage is defined as the percentage change in EPS divided by the
percentage change in EBIT.
DFL = %Δ in EPS
%Δ in EBIT
Where, EPS is earning per share

EPS = (EBIT-I) (1-T)-D

N
Where, N is number of common stock outstanding shares.

Or
DFL = EBIT
EBIT-I-L-D/(1-T)
Where, I is interest payment
L is lease payment
D is dividend payment
T is tax rate

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Unlike interest and lease payments, preferred dividends are not tax deductible. Therefore,
dividend payment has to be adjusted by dividing with (1-T) to make it on equivalent
basis.
Example,
A firm has a base level of 500,000 units of sales and increase to 600,000 units. The sales
price per unit is $10.00 and variable costs per unit are $6.50. Total annual operating fixed
costs are $1,250,000, and the annual interest expense is $100,000. The firm paid 80,000
for preferred stock holders and has 60,000 outstanding shares of common stock. The firm
tax rate is 40%.
1. What is the firm’ earning per share?
2. What is the firm’s degree of financial leverage (DFL)?
Solution:
1. EPS = (EBIT-I) (1-T)-D
N
EBIT = 500,000(10-6.50)-1,250,000=500,000
EPS = (500,000-100,000) (1-0.4)-80,000
60,000
=2.67
If sales increases from 500,000 to 600,000 units the resulting EBIT and EPS is:
EBIT = 600,000(10-6.50)-1,250,000=850,000
EPS = (850,000-100,000) (1-0.4)-80,000
60,000
=6.16
DFL = %Δ in EPS
%Δ in EBIT

= (6.16-2.67)/2.67
(850,000-500,000)/500,000
=1.307/0.7= 1.87
or
DFL = EBIT
EBIT-I-L-D/(1-T)
= . 500,000 .
500,000-100,000- 80,000/(1-0.4)
=1.87
Financial break even
It is defined as the value of EBIT that makes EPS equal to zero. At financial break even,
the firm’s EBIT is just sufficient to cover its fixed financing costs (interest and preferred
Stock dividends) on a before tax basis leaving no earnings for common shareholders.
(EBIT-I)(1-T)-D= EPS
N
(EBIT-I)(1-T)-D= 0 (EBIT-I)(1-T)-D = 0
N EBIT-I = D
(1-T)

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EBIT= D + I
(1-T)

Combined leverage
It is defined as the potential use of fixed costs, both operating and financial, to magnify
the effect of changes in sales on the firm’s earnings per shares (EPS). It is a combination
of operating and financial leverage. Combined leverage measures the relationship
between output and EPS.
Degree of combined leverage ( DCL) = %Δ in EPS
%Δ in output
or The DCL is the product of DOL times DFL. That is:
DCL = DOL X DFL
or
DCL = DOL X DFL
or
= Q (P-V) x EBIT
Q (P-V)-F EBIT-I-L-D/(1-T)
= Q (P-V)
Q (P-V)-F-I-L-D/ (1-T)

Example,
A firm has a base level of 15,000 units of sales and increase to 16,500 units. The sales
price per unit is $50.00 and variable costs per unit are $30. Total annual operating fixed
costs are $150,000, and the annual interest expense is $40,000. The firm paid 20,000 for
preferred stock holders and has 10,000 outstanding shares of common stock. The firm tax
rate is 40%.
1. What is the firm’ earning per share at an output level of 15,000 and 16,500 units?
2. What is the firm’s EBIT, Degree of operating leverage (DOL) and degree of financial
leverage at output level of 15,000 (DFL)?
3. What is the firm’s Degree of combined leverage( DCL)?
Solution:
. EPS = (EBIT-I) (1-T)-D
N
EBIT = 15,000(50-30)-150,000=150,000
EPS = (150,000-40,000) (1-0.4)-20,000
10,000
=4.6
if output increased to 16,500 units, EPS increase to:
EPS = (EBIT-I) (1-T)-D
N
EBIT = 16,500(50-30)-150,000=180,000
EPS = (180,000-40,000) (1-0.4)-20,000
10,000
=6.4
DCL = %Δ in EPS
%Δ in output

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= (6.4-4.6)/4.6
(16,500-15,000)/15,000
=3.91

DOL =1+ F = 1 + 150,000

EBIT 150,000
1+1= 2
DFL = EBIT
EBIT-I-L-D/(1-T)

= . 150,000 .
150,000-40,000- 20,000/(1-0.4)
=1.957
Therefore, DCL = DOL X DFL
=2 x 1.957
=3.91
Note: the firm’s DCL describes the effect that sales changes will have on EPS. However,
we must be careful to realize the approximate nature of this calculation. If the anticipated
sales change is beyond the relevant range of sales describe earlier, the variable cost ratio
may change, and if the time period is too long, fixed costs may change.

Financial leverage and Capital structure

 Optimal capital structure is the capital structure that minimizes the firm’s
weighted average cost of capital and maximizes the value of the firm to its
investors. If the firm currently has an optimal capital structure, it will finance new
investments by a financing mix approximately like the current mix. If the current
capital structure is not optima, the firm should finance new asset in such a manner
that the capital structure will be moved toward the optimal position.

1.5 The theory of capital structure

There are two views regarding capital structure and firm value: the traditionalists’ view
and modernists’ view.
Traditionalists believe that as a firm moves from a position of zero debt to small amounts
of debt, leverage increases the equity holders’ risk but does not increase significantly the
risk born by debt holders. Traditionalist argued that because debt is cheaper, combining
equity with reasonable amounts of debt results a reduction in the firm’s overall cost of
capital, or rA.

Traditionalists believe that too much debt can be bad thing. Look at what happens to the
cost of debt and equity as debt levels go from low to high. First, the cost of debt, which
initially did not raise much, now starts to rise substantially as debt holders become highly
concerned about the firm’s ability to generate enough income to cover promised debt
payments. Second, at high debt levels, the cost of equity also rise quickly because equity
holders know that high amounts of debt are accompanied by high amounts of fixed
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interest payment, increasing the chance that they as residual claimants will end up with
little or no return on their investment, thus, following the traditionalists’ argument, the
overall cost of capital of the firm begins to rise at high levels of debt

The modernists’ position on the use of debt and the value of the firm was established by
Franco Modigliani and Merton Miller in the late 1950s. The modernist position states
that, under ideal conditions, all capital structures produce the same total cost of capital to
the firm and the same total firm value. Modernists believe that the financing decision is
irrelevant.

There is no dramatic point at which the cost of equity rapidly rises. The required rate of
return on equity rises less quickly when greater debt usage begins to transfer some of the
firm’s risk to the debt holders. The required return on equity (rE) begins to flatten out or
rise less steeply at higher levels of debt. This reflects the fact that as debt holders begin to
bear more and more risk, the increased risk borne by equity holders is reduced. With the
modernist view there is no optimum capital structure and firms do not have debt capacity.

Modigliani and Miller( M&M) Propositions I and II with no taxes

It is a famous argument advanced by two Nobel laureates, Franco Modigliani and Merton
Miller, whom we will hence forth call M&M.

A) M&M Proposition I: The Pie Model

Proposition I states that the value of the firm is independent of its capital structure. M&M
proposition I is to imagine two firms that are identical on the left hand side of balance
sheet. Their assets and operations are exactly the same. The right hand sides are different
because the two firms finance their operations differently. It can be view the capital
structure in pie model. As we can see in figure 2.4, two possible ways of cutting up the
pie between equity slice and debt slice 40%-60% and 60%-40%. However, the size of the
pie is the same for both firms because the value of the assets is the same. This is what
M&M Proposition I states: The sIZe of the pie doesn’t depend on how it is sliced.

B) M&M Proposition II: The Cost of Equity and Financial Leverage.

Although changing the capital structure of the firm may not change the firm’s total value,
it does cause important changes in the firm’s debt and equity. Let us see what happens to
a firm financed with debt and equity when the debt/equity ratio is changed.
M&M proposition II stated that weighted average cost of capital, WACC, is:

WACC= E/V x RE + D/V x RD

Where V= E + D
E= equity
D= debt
RE= cost of equity
RD= cost of debt

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WACC is the required return on the firm’s overall assets and it is also labeled as RA
RA = E/V x RE + D/V x RD, if we arrange this to solve for the cost of equity capital
(RE):
RE = RA + (RA- RD) x (D/E)

M&M proposition stated that a firm’s cost of equity capital is a positive linear
function of its capital structure. The cost of equity depends on three things: the
required rate of return on the firm’s assets, RA, the firm’s cost of debt, RD, and the
firm’s debt/equity ration, D/E

As shown M&M proposition II indicates that the cost of equity, RE, is given by the straight line with a slope of (RA-RD).
The y-intercept corresponds to a firm with a debt/equity ratio of zero, so RA=RE. As the firm raises its debt/equity ratio,
the increase in leverage raises the risk of the equity and therefore the required return or cost of equity (RE). Notice that
the WACC doesn’t depend on the debt/equity ratio; it’s the same no matter what the debt/equity ratio is. The firm’s
overall cost of capital is unaffected by its capital structure. As illustrated in figure 2.5, the fact that the cost of debt is
lower than the cost of equity is exactly offset by the increase in the cost of equity form borrowing. In other words, the
change in the capital structure weights (E/V and D/V) is exactly offset by the change in the cost of equity (RE), so the
WACC stays the same.

Example,
The RRR Corporation has a weighted average cost of capital (unadjusted) of 12
percent. It can borrow at 8 percent. Assume that RRR has a target capital structure of
80 percent equity and 20 percent debt.
Required:
1. What is its cost of equity?
2. What is the cost of equity if the target capital structure is 50 percent equity?
3. Calculate the unadjusted WACC using your answers to verify that it is the same
Solution:
1. According to M&M proposition II,
RE = RA + (RA- RD) x (D/E)
=12% + (12%-8%) x (0.2/0.8)
=13%
2. RE = RA + (RA- RD) x (D/E)
=12% + (12%-8%) x (0.5/0.5)
=16%
3. The unadjusted WACC assuming that the percentage of equity financing is 80%
and the cost of equity is 13%:
WACC= E/V x RE + D/V x RD
= 0.8 x 13% + 0.2 x 8%
=12%
As we calculated, the WACC is 12 percent in both cases.

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Modigliani and Miller (M&M) Propositions I and II with taxes

Debt has two features. First, interest paid on debt is tax deductible. This is good for the
firm. Second, failure to meet debt obligations can result in bankruptcy. This is not good
for the firm, and it may be an added cost of debt financing. To see the effect of tax on
M&M Propositions let us consider two firms, Firm U (unlevered) and Firm L (levered).
These two firms are identical on the left hand side of the balance sheet, so their assets and
operations are the same. Assume that EBIT is expected to be birr 1000 every year forever
for both firms. The difference between them is that firm L has issued birr 1000 worth of
perpetual bonds on which it pays 8 percent interest each year. Also assume that the
corporation tax rate is 30%.
Firm U Firm L
EBIT birr 1,000 birr 1,000
Interest (8% x 1000) 0 80
EBT 1,000 920
Tax (30%) 300 276
NI 700 644

The interest tax shield

To simplify things, assume that depreciation is zero and that there is no additional capital
expenditure and net working capital. In this case, cash flow from assets is equal to EBIT-
Taxes. For firms U and L the cash flow from assets would be birr (1000-300=700) and
(1000-276=724), respectively. See that the capital structure is now having some effect
because the cash flows from U and L are not the same even though the two firms have
identical assets. The total cash flow to L is birr 24 more. This is because an interest
deductible for tax purposes has generated a tax saving equal to the interest payment
multiplied by the tax rate: 80 x 30% = birr 24. This is interest tax shield, a tax saving
attainted by a firm from interest expense.

A. Taxes and M&M Proposition I

Since the debt is perpetual, the same birr 24 shield will be generated every year forever.
The after tax cash flow to L will thus be the same birr 700 that U earns plus the birr 24
tax shield. Since L’s cash flow is always birr 24 greater, firm L is worth more than Firm
U by the value of this birr 24 perpetuity. Because the tax shield is generated by paying
interest, it has the same risk as the debt, and 8 percent (the cost of debt) is therefore the
appropriate discount rate. The value of the tax shield is thus:
PV= birr 24/0.08 = 0.3 x 1,000 x 0.08
0.08
= 0.3(1000) = 300
The present value of the interest tax shield can be written as:
V L = VU + T C x D
We have now come up with another famous result, M&M Proposition I with taxes. We
have seen that the value of levered firm (VL) exceeds the value of unlevered firm (VU) by
the present value of the interest tax shield; Tc x D. M&M Proposition I with taxes
therefore states that:
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PV = ( Tc x RD x D)
RD
PV = Tc x D
Where, Tc is tax rate, RD is cost of debt and D is debt

SUPpose that the cost of the capital for the firm U is 10 percent (UNlevered
cost of capital, RU = 10%). This is the cost of capital that the firm woULd have
if it had no debt. Firm U’s cash flow is birr 700 every year forever. The
valUE of the UNlevered firm, VU, is:

VU = EBIT x (1-TC)
RU

VU = 1000 x (1-0.3)
0.10
= 7,000
The value of the levered firm, VL, is:
V L = VU + T C x D
= 7,000 + 0.3 x 1,000
= 7,300
As indicated in figure 2.6, the value of the firm goes up by birr 0.30 for every 1 birr in debt. It is difficult to imagine why any
corporation would not borrow to the absolute maximum under these circumstances. The result of the analysis in this section is
that, if tax is included, capital structure definitely matters. However, we reach the illogical conclusion that
the optimal capital structure is 100 percent debt

B. Taxes, the WACC, and Proposition II

The conclusion that the best capital structure is 100 percent debt also can be seen by
examining the weighted average cost of capital (WACC). If tax is considered, the WACC
is computed as:

WACC = E/V X RE + D/V X RD X (1-TC)

Where V = D + E

To calculate WACC, we need to know the cost of equity. M&M Proposition II with
corporate taxes states that the cost of equity is:

RE = RU + (RU – RD) X (D/E) X (1-TC)

To illustrate, recall that firm L is worth birr 7,300 total (total asset of the firm). Since the
debt is worth birr 1,000, the equity must be worth 7,300-1,000 =6,300 birr. For firm L,
the cost of equity is thus:
RE = RU + (RU – RD) X (D/E) X (1-TC)
= 10% + (0.1-0.08) x (1,000/6,300) x (1-0.30)
=10.22%
Therefore, the weighted average cost of capital is:
WACC = E/V X RE + D/V X RD X (1-TC)
= 6,300/7,300 x 10.22% + 1,000/7,300 x 8% x (1-0.3)

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= 9.6%
Without debt, the WACC is 10 percent, and, with debt, it is 9.6 percent. Therefore, the
firm is better off with debt. As the WACC decrease the value of the firm increase.

Example,
You are given the following information for FAF Corporation:
EBIT = birr 151.52
Tc = 34%
D = birr 500
RU = 20%. The cost of debt capital is 10 percent. What is the value of FAF’s equity? What
is the cost of equity capital for FAF? What is the WACC?

Solution:

Remember that all the cash flows are perpetuities. The value of the firm if it had no debt,
VU, is:
VU = EBIT x (1-TC)
RU
= 151.52 (1-0.34)
0.20
= birr 500
From M&M Proposition I with taxes, we know that the value of the firm with debt is:
V L = VU + T C x D
= 500 + 0.34 x 500
= birr 670
Since the firm is worth birr 670 total and the debt is worth birr 500, the equity is worth
birr 170:
E = VL – D
= 670- 500 = 170
Thus, from M&M Proposition II with taxes, the cost of equity is:
RE = RU + (RU – RD) X (D/E) X (1-TC)
= 0.20 + (0.20-0.10) x (500/170) x (1-0.34)
= 39.4%
Finally, the WACC is:
WACC = E/V X RE + D/V X RD X (1-TC)
= (170/670) x 39.4% + (500/670) x 10% x (1-0.34)
= 14.92%
Notice that this is substantially lower than the cost of capital for the firm with no debt
(RU = 20%), so debt financing is highly advantageoUS.

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