LEVERAGE AND CAPITAL

STRUCTURE

Ms.S.VINOTHINI

ASSISTANT PROFESSORDEPARTMENT OF COMMERCE WITH CA

KONGUNADU ARTS AND SCIENCE COLLEGECOIMBATORE – 641 029

Leverage

Leverage refers to the effects that fixed costs have onthe returns that shareholders earn; higher leveragegenerally results in higher, but more volatile returns.

▫ Fixed costs are costs that do not rise and fall with changesin a firm’s sales volume. Firms have to pay these fixed costswhether business conditions are good or bad.

▫ Generally, leverage magnifies both returns and risks.

Capital structure is the mix of long-term debt andequity maintained by the firm.

Leverage (cont.)

• Operating leverage isconcerned with therelationship between the firm’ssales revenue and its earningsbefore interest and taxes(EBIT) or operating profits.

• Financial leverage isconcerned with therelationship between the firm’sEBIT and its common stockearnings per share (EPS)

General Income Statement Format and

Types of Leverage

Leverage: Operating Leverage

Operating leverage is the use of fixed operating costs

to magnify the effects of changes in sales on the firm’searnings before interest and taxes.

The figure on the following slide uses the data for

Cheryl’s Posters (sale price, P = $10 per unit; variable

operating cost, VC = $5 per unit; fixed operating cost,

FC = $2,500)

Leverage: Operating Leverage (cont.)

The degree of operating leverage (DOL) is the

numerical measure of the firm’s operating leverage.

As long as DOL is greater than 1, there is operating

leverage.

Leverage: Financial Leverage

Financial leverage is the use of fixed financial costs to

magnify the effects of changes in earnings before

interest and taxes on the firm’s earnings per share.

The two most common fixed financial costs are (1)

interest on debt and (2) preferred stock dividends.

Leverage: Financial Leverage (cont.)

The degree of financial leverage

(DFL) is the numerical measure

of the firm’s financial leverage.

Whenever DFL is greater than 1, there is financial

leverage.

Leverage: Financial Leverage (cont.)

A more direct formula for calculating the degree offinancial leverage at a base level of EBIT is thefollowing:

Note that in the denominator, the term 1/(1 – T)converts the after-tax preferred stock dividend to abefore-tax amount for consistency with the other termsin the equation such as interest expense.

The firm’s Capital Structure: Types of Capital

All of the items on the right-hand side of the firm’s balance sheet,

excluding current liabilities, are sources of capital. The following

simplified balance sheet illustrates the basic breakdown of total

capital into its two components, debt capital and equity capital.

The firm’s Capital Structure: Types of Capital (cont.)

• The cost of debt is lower than the cost of other forms of

financing.

• Lenders demand relatively lower returns because they take the

least risk of any contributors of long-term capital.

• Lenders have a higher priority of claim against any earnings or

assets available for payment, and they can exert far greater legal

pressure against the company to make payment than can owners

of preferred or common stock.

• The tax deductibility of interest payments also lowers the debt

cost to the firm substantially.

The firm’s Capital Structure: Types of Capital (cont.)

• Unlike debt capital, which the firm must eventually repay,

equity capital remains invested in the firm indefinitely—it has

no maturity date.

• The two basic sources of equity capital are (1) preferred stock

and (2) common stock equity, which includes common stock

and retained earnings.

• Common stock is typically the most expensive form of equity,

followed by retained earnings and then preferred stock.

• Whether the firm borrows very little or a great deal, it is

always true that the claims of common stockholders are riskier

than those of lenders, so the cost of equity always exceeds the

cost of debt.

THANK YOU

Ms.S.VINOTHINI

ASSISTANT PROFESSOR

DEPARTMENT OF COMMERCE WITH CA

KONGUNADU ARTS AND SCIENCE COLLEGE

COIMBATORE – 641 029

A lease is a contractual arrangement calling for the

lessee (user) to pay the lessor (owner) for use of an

asset. Property, buildings and vehicles are common

assets that are leased. Industrial or business

equipment is also leased.

Leasing has emerged as an important

source of long-term financing of

corporate enterprises during the recent

few decades.

LEASE AGREEMENT

The lease agreement sets

forth the period covered by the

lessee, provisions for payment of

taxes, insurances, maintenance

expenses and the like, provisions

for renewal of the lease or

purchase of the asset at expiration

and the timing and amounts of

periodic rental payments during

the lease period.

Financial Lease

Operating Lease

Conveyance Type lease

Leveraged Lease

Sale and Leaseback

Partial Pay-Out Lease

Consumer Leasing

Ballon Lease

Close end leasing

Swap Leasing

Wrap Leasing

Import Leasing

Cross Border leasing

International Leasing

TYPES OF LEASE

Financial Lease

Also called „Capital Lease‟A contract involving payment over an

obligatory period, of specified sums sufficient

in total to amortize the capital outlay , besides

giving some profit to the lessor.

ICAI defines it as : financial lease is a lease

under which the present value of the minimum

lease payments at the inception of the lease

exceeds or is equal to substantially the whole

of the fair value of the leased asset.”

It is non-cancelable in nature.

The lessee is responsible for the

maintenance of the asset leased.

The lease generally provides for the renewal

of the lease on expiry of the lease contract.

Variants : full payout lease , True Lease

An operating lease is a type of lease whereby

the asset is not fully amortized during the non-

cancelable period of the lease , and where the

lessor does not rely on the lease rentals for

profits.

Short term lease on a period to period basis.

Period of the lease is less than useful life of

the asset.

The lease is cancelable at short notice by the

lessee.

The lessee has the option of renewing the

lease after the expiry of the lease period

Asset maintenance and insurance etc. is the

responsibility of the lessor and he charges for

the same.

It is a high risk lease to the lessor, as any

time it may be cancelled by the lessee.

Net Lease :

A variant of operating lease, where the

lessor is not concerned with the repairs and

maintenance of the leased asset.

Lessor does not provide: - repairs,

maintenance, servicing of lease property -

purchasing parts and accessories. - loan of a

replacement/substitute - purchase of

insurance for the lessee.

Conveyance Type Lease :

Very long type of lease applicable toimmovable property.

Objective to convey the title inproperty.

Lease periods as long as 99 to 999years.

Leveraged Lease:

Where a financier is involved for thewhole or a part of the financial requirement.

Used for high value asset.

The financier will have charge over theleased asset, over and above the lease rentals.

Sale and Leaseback:

Owner of the asset sells it to the

lessor, and gets the asset back under the lease

agreement.

Ownership transfer from the original

owner to the lessor, who again leases out the

asset.

Immediate financing to the seller

company, whose funds are tied up in the asset.

Partial pay out lease:

Full payment of the lease in several

leases.

Consumer Leasing :

Leasing of consumer durables like

Refrigerator, televisions, etc.

Balloon Lease :

A lease which has zero residual value

at the end of the lease period. i.e. low lease

rentals at the inception, high in the mid years,

and low again at the end of the lease.

Close end leasing :

The asset is reverted to the lessor at

the end of the lease.

Open end leasing :

The lessee guarantees a minimum

value to the lessor , from the sale of the asset

at the end of the lease term. If on sale of the

asset, the residual value is less , then lessee

pays to the lessor the difference amount.

Import Leasing : -

Leasing of imported capital goods. -

beneficial to the lessee, because arranging

other sources of funds takes long.

Lenders do not usually finance the

import duty which forms sizable portion of the

cost. - during which the prices of imported

goods may rise + fluctuation in exchange rates

may happen.

Cross Border Leasing :

A lease where the lessor is in one countryand lessee in another.

The Jurisdiction of lessors and lessees arein two different countries.Eg. Leasing of airplanes.

International Leasing:

A case where the leasing company isoperating in various countries through itsbranches.

International leasing is active in countrieslike U.S., Japan, HongKong etc.