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    Chapter 3 Capital Structure and Leverage

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    Jishan Mahmud-1220
    The document discusses capital structure, which refers to the combination of long-term debt and equity used by a company to finance its overall operations and business goals. It describes the main components of capital structure as equity (common stock, retained earnings, preferred stock) and debt capital. A key difference between equity and debt is that debt holders have a senior claim on income/assets compared to equity holders. An optimal capital structure balances the costs and financial risks of different funding sources. Leverage refers to the use of debt financing, which can increase returns but also increases financial risk for the company.

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    © All Rights Reserved
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    Chapter 3 Capital Structure and Leverage

    Uploaded by

    Jishan Mahmud-1220
    198 views14 pages
    The document discusses capital structure, which refers to the combination of long-term debt and equity used by a company to finance its overall operations and business goals. It describes the main components of capital structure as equity (common stock, retained earnings, preferred stock) and debt capital. A key difference between equity and debt is that debt holders have a senior claim on income/assets compared to equity holders. An optimal capital structure balances the costs and financial risks of different funding sources. Leverage refers to the use of debt financing, which can increase returns but also increases financial risk for the company.

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    Chapter 3 capital structure and leverage.ppt

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    The document discusses capital structure, which refers to the combination of long-term debt and equity used by a company to finance its overall operations and business goals. It describes the main components of capital structure as equity (common stock, retained earnings, preferred stock) and debt capital. A key difference between equity and debt is that debt holders have a senior claim on income/assets compared to equity holders. An optimal capital structure balances the costs and financial risks of different funding sources. Leverage refers to the use of debt financing, which can increase returns but also increases financial risk for the company.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    198 views14 pages

    Chapter 3 Capital Structure and Leverage

    Uploaded by

    Jishan Mahmud-1220
    The document discusses capital structure, which refers to the combination of long-term debt and equity used by a company to finance its overall operations and business goals. It describes the main components of capital structure as equity (common stock, retained earnings, preferred stock) and debt capital. A key difference between equity and debt is that debt holders have a senior claim on income/assets compared to equity holders. An optimal capital structure balances the costs and financial risks of different funding sources. Leverage refers to the use of debt financing, which can increase returns but also increases financial risk for the company.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 14

    1

    Definition
    Capital structure shows the combination
    of long term debt and equity. Actually it
    shows the sources of capital.
    Without capital business cannot do its
    work properly, so its capital structure
    should be an indicator of wisdom, best
    financial management practice.

    2
    Types of capital
    1) Equity (common stock+retained
    earnings+ preferred stock)
    2) Debt capital

    3
    Difference between equity and
    debt
    1. Can voice in the 1. Cannot voice in the
    management. management
    2. In case of claim on 2. In case of claim on
    income and asset, income and asset,
    subordinate to debt. senior to equity.
    3. No maturity. 3. Stated maturity.
    4. Interest deduction is 4. Interest deduction is
    not possible. possible.
    5. Cost is greater than 5. Cost is less than
    debt. equity.

    4
     Common stockholders are called the
    residual claimers of the firm as they
    have to carry the risk of not getting
    anything from the firm if there is any
    loss but the debt holders get a fixed
    portion of income so, they do not take
    any risk. But the debt holders can exert
    greater legal pressure on the firm.
    5
    The optimal capital structure
    EBIT (1  T )
    V
    Kd
    EBIT  Earnings before interest and tax
    V  Value of the firm
    T  Tax rate
    K d  Weighted average cost of capital

    6
    External assessment of capital
    structure
    Any investor can assess the performance
    of the firm (debt payment capacity)
    having seen some ratio of financial
    statements:
    1. Debt ratio
    2. Time interest earned ratio
    3. Fixed-payment coverage ratio.

    7
    Leverage
     The use of various financial instruments or
    borrowed capital, such as margin, to
    increase the potential return of an
    investment.
     The amount of debt used to finance a firm's
    assets. A firm with significantly more debt
    than equity is considered to be highly
    leveraged.
    8
    Operating leverage
     Operating leverage involves using a large proportion of
    fixed costs to variable costs in the operations of the firm.
    The higher the degree of operating leverage, the more
    volatile the EBIT figure will be relative to a given change in
    sales. It is a measure of leverage, and of how risky, or
    volatile, a company's operating income is
     Operating leverage is the change in EBIT caused by a
    change in quantity sold.
     The higher the proportion of fixed costs within a firm’s
    overall cost structure, the greater the operating leverage.

    9
     Higher operating leverage leads to
    more business risk, because a small
    sales decline causes a larger EBIT
    decline.
    $ Rev. $ Rev.
    TC } EBIT
    TC
    F
    F

    QBE QBE Sales (More...)


    Sales
    10
    Probability Low operating leverage

    High operating leverage

    EBITL EBITH

     In the typical situation, higher


    operating leverage leads to higher
    expected EBIT, but also increases risk.
    11
    Financial leverage
     A ratio that measures the sensitivity of a company’s
    earnings per share (EPS) to fluctuations in its
    operating income, as a result of changes in its capital
    structure. Degree of Financial Leverage (DFL)
    measures the percentage change in EPS for a unit
    change in earnings before interest and taxes (EBIT).
     The higher the proportion of fixed costs within a
    firm’s overall cost structure, the greater the financial
    leverage.

    12
    Effect of capital structure on firm’s
    return
    or, Impact of Leverage on Returns
     Firm U Firm L
     No debt $10,000 of 12% debt
     $20,000 in assets $20,000 in assets
     40% tax rate 40% tax rate

    Both firms have same operating


    leverage, business risk, and EBIT of
    $3,000. They differ only with respect to
    use of debt. 13
    Impact of Leverage on Returns

    Firm U Firm L
    EBIT $3,000 $3,000
    Interest 0 1,200
    EBT $3,000 $1,800
    Taxes (40%) 1 ,200 720
    NI $1,800 $1,080

    ROE 9.0% 10.8%


    14

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