13

Chapter

CAPITAL STRUCTURE AND LEVERAGE

Capital Structure Defined

The term capital structure is used to represent the proportionate relationship

between debt and equity.

The various means of financing represent the financial structure of an enterprise.

The left-hand side of the balance sheet (liabilities plus equity) represents the

financial structure of a company. Traditionally, short-term borrowings are excluded

from the list of methods of financing the firm’s capital expenditure.

Questions while Making the Financing Decision

How should the investment project be financed?

Does the way in which the investment projects are financed matter?

How does financing affect the shareholders’ risk, return and value?

Does there exist an optimum financing mix in terms of the maximum value to the

firm’s shareholders?

Can the optimum financing mix be determined in practice for a company?

What factors in practice should a company consider in designing its financing

policy?

Features of An Appropriate Capital Structure

capital structure is that capital structure at that level of debt – equity proportion

where the market value per share is maximum and the cost of capital is minimum.

Appropriate capital structure should have the following features

Profitability / Return

Solvency / Risk

Flexibility

Conservation / Capacity

Control

Determinants of Capital Structure Seasonal Variations

Tax benefit of Debt

Flexibility

Control

Industry Leverage Ratios

Agency Costs

Industry Life Cycle

Degree of Competition

Company Characteristics

Requirements of Investors

Timing of Public Issue

Timing of Public Issue

Legal Requirements

Patterns / Forms of Capital Structure

Following are the forms of capital structure:

Complete equity share capital;

Different proportions of equity and preference share capital;

Different proportions of equity and debenture (debt) capital and

Different proportions of equity, preference and debenture (debt) capital.

Approaches to Determine Appropriate Capital Structure

EBI T – EPS Approach – This approach is helpful to analyze the impact of debt

on earnings per share.

Valuation Approach – This approach determines the impact of debt use on the

share holders value and

Cash Flow Approach - This approach analyses the firm’s debt service capacity

Meaning of Financial Leverage

The use of the fixed-charges sources of funds, such as debt and preference

capital along with the owners’ equity in the capital structure, is described as

financial leverage or gearing or trading on equity.

The financial leverage employed by a company is intended to earn more

return on the fixed-charge funds than their costs. The surplus (or deficit) will

increase (or decrease) the return on the owners’ equity. The rate of return on

the owners’ equity is levered above or below the rate of return on total

assets.

Measures of Financial Leverage

Debt ratio

Debt–equity ratio

Interest coverage

The first two measures of financial leverage can be expressed either in terms

of book values or market values. These two measures are also known as

measures of capital gearing.

The third measure of financial leverage, commonly known as coverage ratio.

The reciprocal of interest coverage is a measure of the firm’s income gearing.

Financial Leverage of Ten Largest Indian Companies, 2006Company Capital Gearing Income Gearing

Debt ratio Debt–equity ratio Interest coverage Interest to EBIT ratio

1. Indian Oil 0.556 1.25:1 4.00 0.250

2. HPCL 0.350 0.54:1 5.15 0.194

3. BPCL 0.490 0.96:1 5.38 0.186

4. SAIL 0.858 6.00:1 - ve - ve

5. ONGC 0.106 0.12:1 53.49 0.019

6. TELCO 0.484 0.94:1 0.99 1.007

7. TISCO 0.577 1.37:1 1.62 0.616

8. BHEL 0.132 0.15:1 8.36 0.120

9. Reliance 0.430 0.75:1 3.46 0.289

10. L&T 0.522 1.09:1 2.31 0.433

11. HLL 0.027 0.03:1 264.92 0.004

12. Infosys 0.000 0.00:1 NA* NA*

13. Voltas 0.430 0.72:1 2.64 0.378

Operating Leverage

Operating leverage may be defined as the firm’s ability to use operating costs to

magnify the effects of changes in sales on its earnings before interest and taxes.

Operating leverage is associated with investment (assets acquisition) activities.

How to calculate OL?

The degree of operating leverage may be defined as the change in the

percentage of operating income (EBIT), for the change in percentage of sales

revenue. The degree of operating leverage at any level of output is arrived at by

dividing the percentage change in EBIT with percentage change in sales. (15) That

is

Degree of Operating Leverage (DOL) = Percentage change in EBIT / Percentage

change in sales

Or

DOL=Contribution / Operating profit (EBIT)

Impact of OL

Operating leverage may be favorable or unfavourable. High degree of operating

leverage indicates that high degree of risk. It is good when revenues are rising and

bad when they are falling.

Operating risk (business risk) is the risk of the firm not being able to cover its fixed

operating costs. The larger the magnitude, the larger the volume of sales required

to cover all fixed costs.

Application of Operating Leverage

It is helpful to know how operating profit (EBIT) would change with

a given change in units produced.

It will helpful in measuring business risk.

Financial Leverage

financial leverage is the ability of the firm to use fixed financial charges to

magnify the effects of changes in EBIT on the firm’s earnings per share.

In other words, financial leverage may be defined as the payment of fixed rate of

interest for the use of fixed interest bearing securities to magnify the rate of

return as equity shares

Financial leverage in computed by the following formula

Financial Leverage = EBIT or operating profit divided by EBT or taxable income

Or

Degree of financial leverage (DFL)= Percentage change in EPS divided by

Percentage change in EBIT

Impact of FL Financial leverage may be positive or negative favorable leverage occurs when the

firm earns more on the assets purchased with the funds, than the fixed cost of their

use and vice versa. Higher the degree of financial leverage leads to high financial

risk.

The financial risk refers to the risk of the firm not being able to cover its fixed

financial costs. Hence, financial manager should take into consideration the level

of EBIT and fixed charges while preparing the firm’s financial plan.

Combined Leverage

The degree of combined leverage may be defined as the percentage change in

EPS due to the percentage change in sales.

Thus the combined leverage is:

% Change in EBIT / % change in sales * % Change in EPS/ % Change in EBIT

= % change in EPS / % Change sales

Or

Contribution / EBT (OR) FL*OL

Impact of CL

The combined leverage can work in both directions. It is favorable if sales increase

and unfavourable when sales decrease.

This is because the change in sales results in more than proportion returns in the

form of EPS. Financial leverage and operating leverage are something like double-

edged sword.

They have tremendous acceleration or deceleration effects on EBIT and EPS. A right

combination of these leverage is blessing for corporate growth, while an improper

combination may prove as a curse. Operating leverage also acts as a check on

financial leverage.

Financial Leverage and the Shareholders’ Return

The primary motive of a company in using financial leverage is to magnify the

shareholders’ return under favourable economic conditions. The role of financial

leverage in magnifying the return of the shareholders’ is based on the

assumptions that the fixed-charges funds (such as the loan from financial

institutions and banks or debentures) can be obtained at a cost lower than the

firm’s rate of return on net assets (RONA or ROI).

EPS, ROE and ROI are the important figures for analysing the impact of

financial leveraged

Assignment for student

Find out the 50 NSE listed Companies and calculate Financial, combined and

Operation leverage and Interprate the same.

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