7/22/2018
Capital Structure
Capital Structure
Factors influence the capital structure decisions
 Four primary factors influence the capital structure
decisions :
• First is the firm’s Business Risk, or the riskiness that
would be inherent in the firm’s operations if it is
used no debt. The greater the firm’s business risk,
the lower the amount of debt that that is optimal.
• The second key factor is the firm’s Tax position. A
major reason for using debt is that interest is tax
deductible, which lowers the effective cost of debt.
Business & Financial Risk
 Business risk
B.R is defined as the uncertainty inherent in projections
of future returns, either on assets (ROA) or on equity
(ROE) , if the firm uses no debt or debt-like financing
(i.e. preferred stock) – it is the risk associated with firm’s
operations.
 Financial risk
The portion of stockholders’ risk , over and above basic
business risk, resulting from the manner in which the firm
is financed is called Financial risk.
Financial risk results from using financial leverage, which
exists when a firm uses fixed income securities, such as
debt and preferred stock , to raise capital.
 Capital structure : The combination of debt and
equity used to finance a firm.
 Target capital structure : The mix of debt, preferred
stock and common equity with which the firm plans
to finance its investments.
 Optimal Capital Structure : Optimal capital structure
is the one that strikes a balance between risk & return
to achieve ultimate goal of maximizing the price of
the stock.
Factors influence the capital structure decisions
 The third important consideration is Financial
Flexibility or the ability to raise capital on reasonable
terms under adverse conditions.
 The forth debt-determining factor has to do with
managerial attitude (conservatism or aggressiveness)
with regard to borrowing . Some managers are more
aggressive than others; hence some firm’s are more
inclined to use debt in an effort to boost profits. This
factor affects the target capital structure.
Degree of Leverage
 Degree of Operating Leverage (DOL)
DOL is defined as the percentage change in operating income
(EBIT) associated with a given percentage change in sales.
DOL is concerned with the upper portion of the Income
Statement.
DOL for a particular level of production and sales, Q, can be
computed using the following equation :
DOL Q = Q ( P–V )____
Q(P–V)–F
DOL , based on dollar sales rather than units, can be computed
using the following equation :
DOL S = S – VC___ = Gross Profit
S –VC –F EBIT
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Degree of Leverage Degree of Leverage

 Degree of Financial Leverage (DFL)
DFL is defined as the percentage change in earnings
available to common stockholders associated with a given
percentage in earnings before interest and taxes.
DFL is concerned with the lower part of the Income
Statement .
DFL indicates about the proportion of fixed financial
obligation exists in the firm’s operation.
 Degree of Total Leverage (DTL)
DTL is defined as the percentage change in EPS that results
from a given percentage change in sales.
DTL shows the effects of both operating leverage and financial
leverage.
The three equivalent equations for DTL :
1. DTL = ( DOL) X ( DFL )

2. DTL = Q (P –V )__
DFL is calculated as follows : Q (P-V) –F- I
DFL = Percentage change in EPS = EBIT___ 3. DTL = ___S –VC___ = Gross Profit
Percentage change in EBIT EBIT – I S – VC – F- I EBIT - I

MATH
Degree of Leverage
 Capital Structure (Effect of debt on the EPS)

Given the following information, calculate (i) Earnings Per

NOTE : I = Interest
Share (EPS) and (ii) Expected Earnings Per Share (iii) Degree
VC = Variable Cost
of Operating Leverage (DOL) (iv) Degree of Financial
F = Fixed Cost
Leverage (DFL) of ABC Company for 2002 if :
S = Sales
(i) Debt / Assets = 0%, (ii) Debt / Assets = 50%

Probability of Indicated sales 0.2 0.6 0.2

Sales (thousand) $ 200 $ 400 $ 600
Fixed Cost (thousand) (80) (80) (80)
Variable Cost (thousand) (120) (240) (360)
Total Cost (Except Interest) (200) (320 ) (440)
EBIT 00 80 160

• Assume the following:

(I) The firm is in the 40 percent tax bracket

(ii) Cost of debt is 12 percent
(iii) The value per share of ABC Company is $ 20
(iv) Total Capital of ABC Company is $ 200000