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Spring Semester

Financial
Management
September 30, 2023

Capital Structure
Flow of Study
▪ What is Capital Structure
▪ What are the components of Capital Structure
▪ What are factors influencing Capital Structure choices
▪ What are the traditional and modern theories related to Capital Structure
▪ What are the practical considerations in making Capital Structure decisions
▪ What is Optimal Capital Structure
▪ What is the Capital Structure decision-making process
Capital Structure
Capital structure refers to the mix of equity and debt financing that a company uses to fund
its operations and investments.
The choice of capital structure can significantly impact a company's risk, cost of capital, and value.

It's a critical decision that requires careful consideration.

▪ A firm without debt in its capital structure is called UNLEVERED FIRM

▪ A firm with debt in its capital structure is called LEVERED FIRM
Components of Capital Structure
Firms finance themselves thru retained earnings (internal financing) and selling securities in
the market (external financing).
External financing is raised both in Private and Public Markets
▪ Private Markets: Private Equity, bank debts, PP of bonds and equity
▪ Public Sources: IPO, equity issues, public bond issues
Sources of financing vary over time and over business cycle

▪ Equity Capital: Equity capital represents ownership in the company and includes common and
preferred stock. Common stock represents the basic ownership share, while preferred stock typically
comes with specific dividend rights.
▪ Debt Capital: Debt capital involves borrowing money, including short-term and long-term debt. Short-
term debt includes loans with maturities typically under one year, while long-term debt includes bonds
and loans with longer maturities.
Key Thoughts for Capital Structure
Managers should choose the capital structure that they believe will have the highest form
value because this capital structure will be most beneficial to the firm’s stockholders.

Value of a Company is the Present Value of its Future Cash Flows discounted at WACC.
Only way any decision can change value of Company is by effecting either Cash Flow or the Cost of
Capital. Both these are affected by the Capital Structure decision.
Factors Influencing Capital Structure Choice
key variables affected by Capital Structure Decision are:
▪ Business risk vs. financial risk: Companies need to strike a balance between business risk (related to their
operations) and financial risk (related to their debt levels).
▪ Flexibility: Capital structure should allow for flexibility to adapt to changing business conditions.
▪ Growth opportunities: Companies with growth potential may prefer equity financing to avoid excessive
debt.
▪ Market conditions: Market conditions can affect the availability and cost of both equity and debt
financing.
Business Risk
Business Risk relates to, or arises from, uncertainty about future operating profits and
capital requirements
It depends on a number of factors, such as:

▪ variability in product demand,

▪ variability in sales prices and input costs,
▪ ability to introduce new or updated products,
▪ domestic and global economic factors, and
▪ higher percentage of fixed costs in total cost structure (Operating Leverage)

A high degree of operating leverage implies that a relatively small change in sales results in
a relatively large change in EBIT, net operating profits after taxes (NOPAT), and return on
invested capital (ROIC).
Financial Risk
Financial risk refers to the possibility of financial loss or uncertainty in a company's
earnings due to its financial obligations
It involves the use of debt or borrowed capital to increase the potential return on equity (ROE) of an
investment or business.

While leverage can enhance returns, it also amplifies financial risk.

Financial risk management is crucial to ensure the long-term sustainability and profitability of an
organization.

Effective risk management helps organizations avoid financial distress, bankruptcy, and potential damage
to their reputation

Financial leverage refers to the use of debt or other fixed-charge financing (such as preferred
stock) to amplify the returns on equity investment (ROE).
Operating Leverage
A Financial concept that measures the sensitivity of a company's operating income (also known
as operating profit or EBIT: Earnings Before Interest and Taxes) to changes in its sales revenue
Contribution Margin % Change in EBIT
Operating Leverage = Or,
Operating Income % Change in Sales
Operating leverage measures how sensitive a company's operating income is to changes in sales revenue.
It is a crucial concept for businesses to consider when making cost structure decisions and assessing their
risk exposure.

A company with high operating leverage has a higher proportion of fixed costs in its cost structure
compared to variable costs.

High operating leverage can amplify profits during periods of growth, but it can also magnify losses during
downturns.
Operating Leverage Question
a. Calculate the degree of operating leverage (DOL) for a company with fixed costs of
$500,000, variable costs per unit of $20, and sales revenue of $1,000,000 on 20,000 units.

b. If a company has fixed costs of $300,000, variable costs of $50 per unit (10,000 units
sold), and a contribution margin of 40%, what is the breakeven point in units?

c. Company A has a DOL of 3, and Company B has a DOL of 5. Which company is more
sensitive to changes in sales volume, and why?

d. What will be the change in operating income if a company with a DOL of 4 experiences a
10% increase in sales revenue.
Operating Leverage Question
a. b.

Revenue = 1,000,000 At Breakeven point, EBIT = 0

Variable Cost (USD 20 per Unit) EBIT = Sales – Variable Cost – Fixed Cost (FC)
Variable Cost = 20,000 * 20 Sales = Price (P) * Quantity (Q)
(-) Variable Cost = 400,000 Variable Cost = Per Unit Variable Cost (VC) * Quantity (Q)

Contribution Margin = 600,000 EBIT = P*Q – VC * Q - FC

(-) Fixed Cost = 500,000 EBIT = 0 means, P*Q – VC * Q – FC = 0
EBIT = 100,000 FC
Breakeven Quantity = Q = (P – VC)
Operating Leverage = 600,000 / 100,000
Operating Leverage = 6.0
FC = 300,000, VC = 50,
Contribution Margin = 40%
c. Company B will be more sensitive to changes
Price = VC/(1-CM) = 50/(1-40%) = 50/60% = 83.33
in Sales volume as it has higher DOL which
shows a higher fixed cost in total cost. Breakeven Quantity = 300,000 / (83.33 – 50)
= 300,000 / 33.33
d. With a DOL of 4x, a 10% change in Sales will = 9,000 Units
result in 40% change in Operating Income.
Financial Leverage
Financial leverage refers to the use of debt or borrowed capital to magnify the potential
returns to equity investors
Operating Income (EBIT) % Change in PAT
Financial Leverage = Or,
Profit before Tax (PBT) % Change in EBIT

Financial leverage can increase returns when the return on invested assets exceeds the cost of borrowing.

The risk arises from the obligation to make interest payments and repay borrowed capital, which can lead
to financial distress if not managed properly.

A high Financial Leverage can enhance profitability but also increases financial risk.
Financial Leverage Question
a. Compute the degree of financial leverage (DFL) for a company with an interest expense of
$50,000, a net income of $200,000, and earnings before interest and taxes (EBIT) of
$300,000. No tax applicable.

b. Company X has a DFL of 2, and Company Y has a DFL of 3. Which company has higher
financial risk, and why?

c. How much will net income change if a company with a DFL of 2 experiences a 15%
increase in EBIT.
Financial Leverage Question
a.
c.
Profit before Tax = Net Income, if no taxes applicable
DFL of 2x indicates that the company’s net
PBT = 200,000 income will change twice that of its operating
EBIT = 300,000 income.
Financial Leverage = 300,000 / 200,000 Thus, Company’s Net Income will increase by
Financial Leverage = 1.5 30% as a result of 15% change in EBIT.

b. Company will higher DFL has more Financial

Risk as its PBT/Net Income/ROE is more sensitive
to changes in Operating Income.

d. With a DOL of 4x, a 10% change in Sales will

result in 40% change in Operating Income.
Combined Leverage
Combined Leverage shows combined impact of DOL and DFL on financials of a company. In
simple words, it shows that sensitivity of company’s change Sales (Revenue) with Change in
Net Income (or, ROE).

Combined Leverage = Operating Leverage * Financial Leverage

Assume a company has an Operating Leverage (DOL) of 3x and Financial Leverage (DFL) of
1.5x, the Combined Leverage will be:

Combined Leverage = DOL * DFL

Combined Leverage = 3.0 * 1.5
Combined Leverage = 4.5
DOL, DFL, and Combined Leverage
Assume the following Financials:
Base Case 20% Sales Growth 20% Sales Decline

Sales 100,000 120,000 80,000 Sales Change by ±20%

Variable Costs 60,000 72,000 48,000
Contribution Margin 40,000 48,000 32,000 2x
Fixed Costs 20,000 20,000 20,000
Operating Profit (EBIT) 20,000 28,000 12,000 EBIT Change by ± 40%
Financial Charges 10,000 10,000 10,000 2x
Profit before Tax 10,000 18,000 2,000 PBT Change by ± 80%
Tax Charge (30%) 3,000 5,400 600 2x
Profit after Tax 7,000 12,600 1,400 PAT Change by ± 80%
Operating Leverage 2.0 → % Change in EBIT will twice of % change in Revenue
Financial Leverage 2.0 → % Change in PBT/NI will twice of % change in EBIT
Combined Leverage 4.0 → % Change in PBT/NI will 4 times of % change in Revenue
Traditional Capital Structure Theories
Several traditional views and theories dominated financial thought provided different
perspectives on how a company's capital structure impacted its value and cost of capital.
Some traditional view include:
▪ Net Income Approach:
o Argued that debt financing was advantageous due to tax efficiency
o Higher levels of debt would lead to increased net income
o Higher debt in Capital Structure reduces WACC, thus, raising firm’s value

▪ Net Operating Income Approach:

o Focused on the relationship between operating income and the value of a leveraged firm.
o Argued that the Operating Income and associated risks derive firm value not its capital
structure.

▪ Traditional Trade-Off Theory:

o Suggested that companies balanced the benefits of debt (tax shield) against the costs (such as
financial distress and bankruptcy risk).
o Implied that an optimal capital structure existed at balanced costs and benefits.
Miller-MODIGLIANI (MM) Approach
Modern capital structure theory began in 1958, when Professors Franco Modigliani and
Merton Miller (hereafter MM) published what has been called the most influential finance
article ever written.
▪ Modigliani and Miller developed the two approaches of capital structure:
o Modigliani and Miller Approach : Without Taxes (1958)
o Modigliani and Miller Approach : With Taxes (1963)

The basic concept of this approach is that the value of the firm is independent of its capital
structure and determine solely by its investment decision.
Miller-MODIGLIANI (MM) Approach [No Taxes]
The approach suggested Value of Firm depends on its cash flows rather than capital structure
under certain conditions (assumptions).

Suggests, Value of Unlevered Firm = Value of Levered Firm

▪ Key Assumptions:
o There are no brokerage costs.
o There are no taxes.
o There are no bankruptcy costs.
o Investors can borrow at the same rate as corporations.
o All investors have the same information as management about the firm’s future
o investment opportunities.
o EBIT is not affected by the use of debt.

▪ Value of the firm following a particular risk category is equal to its expected operating income divided
by the discount rate appropriate to its risk class
Miller-MODIGLIANI (MM) Approach [No Taxes]
MM held two portfolio comprised of:
(1) All Equity Stocks of an Unlevered Firm, and
(2) All Equity Stocks and Debt of a Levered Firm.
They argued that Value of both portfolios will be same as both produces same cash flows.

Portfolio of UNLEVERED Firm Portfolio of LEVERED Firm

▪ In case of Unlevered Firm (assuming no taxes and ▪ In case of Levered Firm (assuming no taxes and
no growth prospects), the Cash Flow will be no growth prospects), the Cash Flow will be
DIVIDEND INCOME for EQUITY HOLDERS DIVIDEND INCOME for EQUITY HOLDERS and
INTEREST for DEBT HOLDERS.
Operating Income (EBIT)
(-) 0% Taxes Operating Income (EBIT)
= Net Income (-) Financial Charges
= Net Income
▪ No GROWTH requires no retention
▪ All Income paid out as Dividend ▪ No GROWTH requires no retention
▪ Cash Flow = Net Income = EBIT ▪ All Income paid out as Dividend
▪ Cash Flow = Net Income + Interest = EBIT
Miller-MODIGLIANI (MM) Approach [No Taxes]
▪ Both Companies produces same cash flow for investors i.e., EBIT
▪ Companies with Same Cash Flows MUST have Same Value

Deducing that Firm’s Value is unaffected by its CAPITAL STRUCTURE

VALUE of UNLEVERED Firm VALUE of LEVERED Firm

▪ Present Value of Free Cash Flows discounted at ▪ Present Value of Free Cash Flows discounted at
WACC WACC
▪ VALUE = EBIT / (1+ WACC) ▪ VALUE = EBIT / (1+ WACC)
▪ VALUE = DIVIDEND / (1+ WACC) ▪ VALUE = (DIVIDEND + INTEREST) / (1+ WACC)
Miller-MODIGLIANI (MM) Approach [No Taxes]
WACC is a weighted combination of Debt & Equity Costs

▪ As leverage increases,
o More weight is given to low-cost debt
o equity becomes riskier, which drives up Cost of Equity

Under MM assumption, Cost of Equity increases exactly enough to keep WACC Constant
Miller-MODIGLIANI (MM) Approach
Proposition I: Without Taxes

▪ Cost of Equity
Value of Debt
Rs = Ru + * (Ru – Rd)
Value of Equity

▪ Weighted Average Cost of Capital (WACC)

Value of Debt Value of Equity

WACC = * (Rd) + * (Rs)
(Value of Debt + (Value of Debt +
Equity) Equity)
Ru = Cost of Equity of Unlevered Firm
Rs = Cost of Equity of Levered Firm
Rd = Cost of Debt
Miller-MODIGLIANI (MM) Approach [With Taxes]
In 1963, MM published a follow-up paper in which they relaxed the assumption that there
are no corporate taxes.
▪ Tax regulations allow interest payments to be deducted as pre-tax expense
▪ Dividend payments to stockholders are not deductible.
▪ The differential treatment encourages corporations to use debt in their capital structures.
▪ Interest payments reduce the taxes liability and increases the cash flow available for investors.

MM suggested that the value of a levered firm is:

▪ the value of an otherwise identical unlevered firm, plus
▪ Present Value of Tax Shield

Value of Levered Firm = Value of Unlevered Firm + PV of Tax Shield (i.e., Tax Rate * Debt)
Under this proposition, with taxes applicable:
▪ Cost of Equity increases with rising debt in capital structure, but
▪ Does not increase as much as in case of no taxes, thus

WACC falls with increasing debt

Miller-MODIGLIANI (MM) Approach
Proposition II: With Taxes

▪ Cost of Equity
Value of Debt
Rs = Ru + * (Ru – Rd) * (1- T)
Value of Equity

▪ Weighted Average Cost of Capital (WACC)

Value of Debt Value of Equity

WACC = * (Rd) * ( 1-T) + * (Rs)
(Value of Debt + (Value of Debt +
Equity) Equity)
Ru = Cost of Equity of Unlevered Firm
Rs = Cost of Equity of Levered Firm
Rd = Cost of Debt
T = Corporate Tax Rate
Miller-MODIGLIANI (MM) Approach [With Taxes]
ABC company is currently unlevered with expected EBIT of PKR 153.85 in
perpetuity. The corporate tax rate is 35% implying after tax earnings of PKR
100. The firm is considering a capital restructuring to allow PKR 200 of Debt.
Cost of debt capital is 10%. Unlevered firms in same industry have cost of
equity of 20%. Value of ABC will be:

𝐸𝐵𝐼𝑇 ∗ (1−𝑇)
Value of Unlevered ABC =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚
153.85 ∗ (1−35%) 100
Value of Unlevered ABC = =
20% 20%
Value of Unlevered ABC = PKR 500

𝐸𝐵𝐼𝑇 ∗ (1−𝑇)
Value of Levered ABC = + T*B
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚
153.85 ∗ (1−35%)
Value of Levered ABC = + 35%*200
20%
100
Value of Levered ABC = +70 = 500+70
20%
Value of Levered ABC = PKR 570
Modern Capital Structure Theories
▪ Pecking Order Theory:
o Suggested that companies preferred internal financing (retained earnings) over external
financing (debt and equity).
o Viewed external financing as a last resort when internal funds were insufficient.
▪ Market Timing Theory:
o Argued that capital structure decisions are based on market conditions.
o Companies might choose to issue equity during periods of high stock prices and debt during
periods of low interest rates.
▪ Agency Cost Theory:
o Focused on the conflicts of interest between shareholders and managers.
o Suggested managers might have an incentive to take on excessive debt, which could benefit
shareholders in the short term but lead to financial distress in the long term.
▪ Signaling Theory:
o MM assumed efficient markets (i.e. everyone has same information; Symmetric Information)
o Managers are better informed than outsiders (Asymmetric Information)
o Argued that announcement of a stock offering is generally taken as a signal that the firm’s
prospects as seen by its own management are not good; conversely, a debt offering is taken
as a positive signal.
Practical Considerations
Following are key practical consideration in a Capital Structure decision:

▪ Industry Norms: Companies often consider what is typical in their industry when making capital structure
decisions.
▪ Regulatory Constraints: Regulations may limit the amount of debt a company can take on.
▪ Credit Ratings: Credit ratings affect a company's ability to borrow and the cost of debt.
▪ Market Perception: Investors' perceptions of a company's capital structure can impact its stock price.
▪ Management’s Preferences: Management's risk tolerance and preferences also influence capital
structure choices.
Key Capital Structure Ratios

▪ Debt to Equity Ratio: It measures the proportion of debt relative to equity in the capital structure.
▪ Debt Ratio: This ratio calculates the percentage of total assets financed by debt.
▪ Equity Ratio: The equity ratio shows the proportion of total assets financed by equity.
▪ Times Interest Earned (TIE) Ratio: TIE measures a company's ability to meet its interest payments from
earnings.
Optimal Capital Structure
The best mix of debt and equity financing that maximizes a company’s market value while
minimizing its cost of capital.
The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the
weighted average cost of capital (WACC) of a company while maximizing its market value.
Estimating Optimal Capital Structure
The basic approach is to consider a trial capital structure, based on the market values of the
debt and equity, and then estimate the wealth of the shareholders under this capital
structure.
This approach is repeated until an optimal capital structure is identified.

Steps in the analysis of each potential capital structure:

1. Estimate the interest rate the firm will pay.
2. Estimate the cost of equity.
3. Estimate the weighted average cost of capital.
4. Estimate the value of operations.
Levered & Unlevered Beta
Beta is the relevant measure of risk for diversified investors.
A firm’s beta increases with financial leverage.

Following Equation summarizes the impact of Financial Leverage on Beta of a Firm:

Beta (Levered Firm) = Beta (Unlevered Firm) * [1 + (1-Tax Rate) * (Debt/Equity)]

Counts Accounting has a beta of 1.15. The tax rate is 40%, and Counts is financed with 20% debt. What is
Counts’ unlevered beta?

Beta (Levered Firm) = Beta (Unlevered Firm) * [1 + (1-Tax Rate) * (Debt/Equity)]

Beta (Unlevered Firm) = Beta (Levered Firm) / [1 + (1-Tax Rate) * (Debt/Equity)]

Beta (Unlevered Firm)= 1.15 / [ 1 + ( 1 – 40%) * (20% / 60%) ]

Beta (Unlevered Firm) = 1.15 / [ 1 + (60%) * (0.67) ] = 1.15 / [1.15] = 1.00