7/30/2019 Capital Structure -Chapter 16, Eugene Brigham-General

1/9

1

CAPITAL STRUCTURE : Chapter 16 (Eugene Brigham)Capital structure:

The debt-equity mix of firm is called capital structure. It is is

the composition of the long term sources of finance of a

company. The sources of long term finance are of equity finance

(e.g. common stock, premium, reserve & surplus/retained

earnings) and debt finance (e.g. debenture, bond, preferred

stock etc). Net working capital is not considered when solelycapital structure is meant

Financial structure:

When working capital is considered along with the capital

structure, it is called financial structure.

Optimum capital structure:

The capital structure at which, the (weighted average) cost of capital is the least and

the market value of the share is the highest, that capital structure is called the

optimum capital structure. When the marginal real cost of all the sources of capital

7/30/2019 Capital Structure -Chapter 16, Eugene Brigham-General

2/9

2

How capital structure decision affect WACC/FCF?

1. Debt increase the cost of stock2. Debt reduces the taxes a company pays

3.The risk of bankruptcy increases the cost of debt

4. The net effect of WACC5. Bankruptcy cost reduces free cash flow

6.Bankruptcy risk affects agency cost

7. Issuing equity conveys a signal to the market place

7/30/2019 Capital Structure -Chapter 16, Eugene Brigham-General

3/9

3

Business risk vs. financial risk

1. Business risk: is the risk inherent in its operation.

It is the risk that a firms common stockholderswould face if the firm had no debt. Business risk

arises from uncertainty in projections of the firms

cash flows, which in turn means uncertainty about

its operating profit and its capital investment

requirement.

2. Financial risk: is the additional risk placed on the

common stockholders as a result of the decision to

finance with debt. Using leverage i.e. has both

good and bad effects: higher leverage increases

expected ROE but it also increases risk.

7/30/2019 Capital Structure -Chapter 16, Eugene Brigham-General

4/9

4

Degree of operating leverage (DOL):The percentage change in EBIT occurring due to agiven percentage change in sales is referred to as the

degree of operating leverage (DOL).

DFL = % changes in EBIT/% changes in sales

=( EBIT/EBIT)/(Sales/Sales)Alternative formula,

DFL = Contribution margin/EBIT

= EBIT+ Fixed cost/EBIT= (EBIT/EBIT) +(Fixed cost/EBIT)

= 1 + (Fixed cost/EBIT)

7/30/2019 Capital Structure -Chapter 16, Eugene Brigham-General

5/9

5

Financial Leverage (FL)The use of the fixed charges sources of fund (such as debt and preference) along withthe owners equity in the capital structure is referred to as thefinancial leverage orgearing ortrading on equity.

Measures of FL:

1. Debt ratio: the ratio of debt to total capital

L1 = D/(D+E)

= D/V2. Debt equity ratio: The ratio of debt to equity.

L2 = D/E

3. Interest coverage ratio: the ratio of net operatingincome (NOI) or EBIT to interest charge.

L3 = EBIT/Interest

7/30/2019 Capital Structure -Chapter 16, Eugene Brigham-General

6/9

6

Degree of financial leverage (DFL):The percentage change in EPS occurring due to a givenpercentage change in EBIT is referred to as the degree of

financial leverage (DFL).

DFL = % changes in EPS/% changes in EBIT

=( EPS/EPS)/(EBIT/EBIT)

Alternative formula,

DFL = EBIT/(EBIT-INT)

= EBIT/PBT

= (PBT+INT)/PBT= (PBT/PBT)+(INT/PBT)

= 1 + (INT/PBT)

7/30/2019 Capital Structure -Chapter 16, Eugene Brigham-General

7/97

Degree of combined leverage (DCL):DFL and DOL can be combined to see the effect of totalleverage on EPS. The degree of combined leverage is given asfollows:

DCL = DFL * DOL

= (% changes in EPS/% changes in EBIT)*

( % changes in EBIT/% changes in sales)

= % changes in EPS/% changes in sales

=( EPS/EPS)/(Sales/Sales)Alternative formula,

DCL = CM/(EBIT-INT)

= CM/PBT

= (PBT+INT+FC/PBT)

= PBT/PBT + (INT+FC/PBT)

= 1+ (INT+FC)/PBT

7/30/2019 Capital Structure -Chapter 16, Eugene Brigham-General

8/9

8

Example-1:

Two firms A and B have the following information:

Firm Sales VC FC

Tk. Tk. Tk.

A 1,800 lac 450 lac 900 lacB 1,500 lac 750 lac 375 lac

Required:

a. Profit to sale ratio b. BEB c. DOL.

d. If sales of the company is increased by 20%, by

how much the profit will increase?

7/30/2019 Capital Structure -Chapter 16, Eugene Brigham-General

9/9

9

Example-2:

Consider the following information for XYZ Ltd:

Particulars Amount

EBIT Tk. 1,120 lacPBT Tk. 320 lac

Fixed cost Tk. 700 lac

Required:

a. DOL, DFL, DCL

d. Calculate the percentage changes in EPS if sales

is increased by 5 percent.