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Financial Management ­ MGT201
VU
Lesson 32
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following
topics:
·  Financial Leverage
·  Capital Structure
First we recap some concepts of previous lectures.
·  WACC % = rD XD + rE XE + rP XP. (Debt, Common Equity, Preferred Equity)
o  Where "r" is ACTUAL COST which can be calculated from REQUIRED ROR after
accounting for Taxes & Transaction Costs.
o  Equity Capital: If Not Enough Retained Earnings then Equity Capital must be financed
by New Stock Issuance which is more costly.
·  Total Risk Faced by FIRM
= Business Risk + Financial Risk
·  Higher Operating Leverage (OL = Fixed Costs / Total Costs)
o  Higher Mean ROE WHEN FIRM'S SALES > BREAKEVEN POINT
o  Higher Fixed Costs means Higher Breakeven Point and More Chances of Operating
Loss. Risk of Large Drop in Return on Equity (ROE) so Higher Risk.
Financial Risk:
From the discussion of the previous lecture we can infer that
Financial Risk = Total Standalone Risk ­ Business Risk
For example, if
Total risk as measured by standard deviation of ROE of levered firm = 30%
and Business risk as measured by standard deviation of ROE of un-levered firm = 20%
then
Financial Risk = 30% - 20% = 10%
Financial Risk is created when firms take loan or debt. As companies take more debt they are exposed
to more financial risk.
Financial Leverage (FL):
Financial Leverage shows the effect that small increase in EBIT can create much larger increase in ROE
of the firm.
Financial Leverage (%) =Debt /Total Assets = Debt / Debt + Equity
If firm has Rs.1000 of total assets and Rs.500 debt then it has 50% (=500/1000) financial leverage. So
this firm has 50% leverage means 50% equity and 50% debt. Practically, firms increase financial
leverage by
­  Issuing New Debt (i.e. Taking New Loans and Increase Debt)
OR
­  Replacing Equity with New Debt ( Increasing debt and increasing equity too)
Financial Leverage Impact on Risk & Return of Firm:
Financial Leverage (or Debt Financing) generally increases overall risk & return of a firm. Let
us have a look now on a table that shows how when a firm becomes levered it increases the variability
of ROE and how it increases the mean ROE.
Effect of Leverage on ROE Volatility & Risk
EBIT
Interest
EBT
Tax
Net Income ROE
(Rs.50)
(30%)
(=NI/Equity)
Un-Levered
600
0
600
180
420
42%
Firm with
300
0
300
90
210
21%
no debt or 100%
50
0
50
15
35
3.5%
equity
Levered firm
600
50
550
165
385
77%
with debt
300
50
250
75
175
35%
50
50
0
0
0
0%
139
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Financial Management ­ MGT201
VU
This table shows the effect on ROE as earnings change from Rs.50 to Rs.600. This variation in
earnings can be due to market forces or random events. This variation in sales revenue can lead to
change in EBIT and this is source of risk. This will lead to change in possible values of ROE. Results of
the table for levered and un-levered firm indicate that leverage (or Debt) increases the spread or range of
possible ROE thereby increasing uncertainty and risk. Financial Leverage (or Debt Financing) generally
increases overall risk & return of a firm due to the following reasons:
·  Increases Return (Mean ROE):
­  When EBIT /Total Assets > Interest Cost then Financial Leverage is Good. Small Increase
in EBIT can create much larger Increase in ROE. If
EBIT /Total Assets > Interest Cost it means firm is generating profit by the use of its debt
resulting in increased ROE as firm has positive cash flows.
­  If Equity (and number of shares) reduced then Return (NI) per Share Increases. By reducing
its equity the firm will increase its percentage of debt in capital structure. As the earnings
are the same to be distributed among lesser number of shares due to reduced equity the
return will increase per share resulting in increased ROE.
These two effects can be visualized in the following graph:
Visualizing Financial Leverage (FL)
Impact on ROE & Capital Structure
LEVERED (Debt
ROE (%)
& Equity) Firm:
77%
Higher Slope.
ROE more
sensitive to
changes in EBIT
42%
35% = <ROE>L
UN-LEVERED
(100% Equity)
21% = <ROE>UL
Firm. Safer
Capital Structure
3.5%
at Low EBIT's
0%
EBIT (Rs)
50
300
600
This is the graphic representation of the above table of Effect of Leverage on ROE Volatility & Risk
for a levered and un levered firm. It indicates that leverage (or Debt) increases the spread or range of
possible ROE thereby increasing uncertainty and risk. Range of possible values of ROE have been
indicated by straight lines while level of risk by the probability distributions.
·  Increases Risk (Standard Deviation in ROE):
­  Fixed Interest Dues so Higher Chances of Losses, No Dividends for Shareholders.
Possibility of Large Drop in ROE.  Possibly Default.  More Risk Transferred to
Stockholders.
­  If Equity (and number of shares) reduced then Risk per Share Increases.
This can also be visualized in the following graph:
140
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Financial Management ­ MGT201
VU
Visualizing Impact of Financial Leverage
on ROE & Capital Structure
Un-Levered (100% Equity):
Lower ROE and Lower Risk.
Levered (Debt & Equity):
Risk
Higher ROE but Higher Risk
Risk
Mean ROE
Mean ROE
<ROE>Levered =
<ROE>Un-Levered
= 21%
35%
Return on Equity ( ROE)%
Capital Structure Theory:
From the discussion of Financial leverage we know Financial Leverage (FL = Debt / (Debt +
Equity))
Increases Overall Return (Mean ROE) when EBIT/Total Assets > Interest (or Cost of Debt)
then Leverage is Good because small Increase in EBIT causes much LARGER Increase in ROE.
Increases Overall RISK (Standard Deviation of ROE) of FIRM. Leverage will always
MAGNIFY or AMPLIFY a small change in EBIT into a LARGER change in ROE.
·  Fundamental Principle in Risk-Return: Rational Investors in Efficient Markets will only take Extra
Risk if they are compensated by Sufficient Extra Return.
·  Should the Management of a Firm undertake Financial Leverage? If so, then how much Debt
should a Firm have?
­  Answer provided by Capital Structure Theory.
Modigliani - Miller:
·  Fathers of Corporate Finance
·  "Cost of Capital, Corporate Finance and the Theory of Investment" Revolutionary Article
Published by Professors Modigliani & Miller in American Economic Review in June 1958.
Won Nobel Prize.
·  "Pure M-M" (or Modigliani-Miller) Model - IDEAL CASE:
There is no fixed ratio for debt in capital structure. Generally it varies with each company's needs
and requirements. Capital structure theory tries to determine the most suitable ratio for a firm.
­  Major Assumptions:  No Taxes, No Bankruptcy Costs, Efficient Markets, Equal
Information Available to All Investors
­  Major Conclusions:
·  Capital Structure has no affect on value of a FIRM! Capital Structure is
Irrelevant!
·  It does NOT matter how a firm finances its operations, how much debt it has
because it has no bearing on a Firm's Overall Value as calculated using NPV!
·  Corporate Financing & Capital Structure Decisions have no bearing on
Investment (or Capital Budgeting) Decisions.
·  Capital Budgeting can be carried out without knowing the exact Capital
Structure of a Firm - you can assume 100% Equity (Un-levered) Firm.
Keep in view these conclusions of the theory are correct only under the ideal conditions as assumed by
Modigliani-Miller.
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Financial Management ­ MGT201
VU
Modified MM - With Taxes:
In order to apply it in the real world for its use, some other economists made some modifications. In
order to make this theory applicable in the real world and to account for the effects of corporate and
personal taxes on investment decision and on firm, the effect of taxes was included in it.
·  Modigliani-Miller (With Corporate Tax)
­  In most countries, a Firm's Interest Payments to Bond Holders are NOT Taxed. But
Dividend Payments to Equity Holders are taxed.
­  Based on CORPORATE TAXES, FIRMS should prefer to raise Capital using DEBT
Financing rather than equity as there is saving associated with capital raised through
this source.
From firms point of view interest payments are source of tax savings.
·  Merton-Miller (With Personal Tax)
­  In most countries, INVESTORS (bondholders and shareholders) pay a higher Personal
Income Tax on Interest Income from Bonds than on Dividend Income from Equity (or
Stocks).
­  Based on PERSONAL TAXES, INVESTORS should prefer to invest in STOCKS (or
Equity).
Uncertain Conclusion: Difficult to determine Net Effect of taxes on optimal capital structure. But,
practically speaking, Corporate Tax Effect is generally stronger so Based on Taxes alone, Firms should
prefer Debt.
We shall discuss other modifications in Modigliani ­ Miller capital structure theory along with the one
discussed above in the next lecture.
142
Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios