CAPITAL STRUCTURE

The firm combines different securities in its assets in an

attempt to maximize its overall market value. Capital structure in

this sense is the firm’s mix of different sources of finance. It refers to

the way a firm finances its assets through some combinations

of equity, debt, or hybrid securities. A firm's capital structure

in this respect is then the composition or structure of its

liabilities but excluding all short term liabilities.

Basically, a firm’s major source of finance is debt and equity. Equity

includes paid up share capital, share premium, reserves and surplus

while debts includes debentures, loan stocks and bonds.

Clearly defined therefore, capital structure refers to the relative

mix of or the proportionate relationship between debt and

equity securities in the long-term financial structure of a

company.

The capital structure decision is a significant managerial and strategic

decision. It influences the shareholders return and risk. Consequently,

the market value of the share may be affected by the capital structure

decision. Thus, whenever funds have to be raised to finance

investments, a capital structure decision is involved.

Hence, the debt-equity mix has implications for the

shareholders’ earnings and risk, which in turn will affect the

cost of capital and the market value of the firm.

OPTIMAL OR TARGET CAPITAL STRUCTURE

The Optimal Capital Structure is the one that minimizes

the firm’s cost of capital and maximizes its value. It is

the mix or combination of debt, preference shares

and equity that will optimize or maximize the

company's share price and minimize its WACC. As a

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company raises new capital it will focus on maintaining

this target or optimal capital structure.

For each company, there is an optimal capital

structure, including a percentage of debt and equity, a

balance between the tax benefits of the debt and the

equity. As a company continues to increase its debt over

the amount stated by the optimal capital structure, the

cost to finance the debt becomes higher as the debt is

now riskier to the lender. The risk of bankruptcy increases

with the increased debt burden. Since the cost of debt

becomes higher, the WACC is also affected. With the

addition of debt, the WACC will at first fall as the

benefits are realized, but once the optimal capital

structure is reached and then surpassed, the increased

debt burden will then cause the WACC to increase

significantly.

CAPITAL STRUCTURE, OPTIMALITY AND THE

VALUE OF A FIRM

The Capital Structure decision of a firm and its optimality are usually

examined from the point of its impact on the value of the firm. If capital

structure decision can affect a firm’s value, then the firm would like to

have a capital structure, which maximizes its market value.

The appropriate questions to ask here is;

‘Is there an optimal capital structure? Does capital structure matter? If it

does, what is the relationship between capital structure and the value of

the firm? Can the total market value of a firm be increased or decreased

by changing the mix of debt and equity financing?’

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The answer to these questions are not farfetched but lies on two

conflicting theories well documented in the literature and established to

explain the relationship between capital structure, optimality and the

value of the firm. These theories include;

Theories of Capital Structure Relevance and

Theories of Capital Structure Irrelevance

In establishing this relationship, certain simplifying assumptions

common to these theories were proposed including;

i. Firms can be financed only through debt and equity

ii. Transaction or floatation cost does not exist

iii. Corporate or personal income taxes does not exist

iv. The ratio of debt to equity of a firm can be changed by

issuing debt to purchase equity or issuing equity to pay

off debt.

v. Bankruptcy costs do not exist.

vi. Individuals can borrow as easily and at the same rate of

interest as the firm.

vii.There are no retained earnings. The firm pays out 100% of

its earnings as dividend.

viii. The operating earnings of the firm are not expected to

grow.

ix. The expected value of the probability distributions of

expected future operating earnings for each company are

the same for all investors in the market.

THEORIES OF CAPITAL STRUCTURE RELEVANCE

Among the leading theories documenting the relevance of capital

structure to the firm’s value includes;

Net Income Approach

Traditional Approach

Modigliani and Miller (M&M) Theory with Taxes

NET INCOME APPROACH

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This theory posits that capital structure is relevant and that the

proportionate use of debt in a firm’s capital structure will increase its

value. It suggests that a firm can vary its value by either increasing or

decreasing it through the financial mix, which is the ratio of debt to

equity. The NI approach is based on the premise that the cost

of debt is cheaper than that of equity and that the optimal

use of debt will result in a decline in WACC.

According to this approach, the average cost of capital (ko) declines

as gearing increases. The cost of shareholders funds (ke) and the cost

of debt (kd) are independent. Since kd is usually less than ke as debt

is less risky than equity from the investor’s point of view, an increase

in gearing should lead to a decrease in ko

As the proponent puts it, the cost of debt is cheaper than that

of equity for the following reasons;

i. Lenders require a lower rate of return than ordinary

shareholders. Debt finance presents a lower risk than shares for

the finance providers because they have prior claims on annual

income and liquidation. In addition security is often provided

and covenants imposed.

ii. A profitable business effectively pays less for debt capital

than equity since debt interest can be offset against pre-tax

profits before the calculation of company tax, thus reducing

the company’s tax liabilities.

iii. Issuing and transaction costs associated with raising and

servicing debt are generally less than for ordinary shares.

The Net Income approach can be demonstrated graphically as

follows;

Rate OfReturn (%)

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Ke

Ko

KD

Debt/Equity

As shown, the cost of equity is constant throughout. An increase in

the level of gearing is consistent with a reduction in the cost of

capital. Thus, as a firm introduces more debt into its capital

structure, the overall cost of capital will decline.

Clearly, the amount of debt that a firm uses to finance its assets is

called leverage. A firm that finances its assets by equity and debt is

called a LEVERED/GEARED firm while a firm that finances its assets

entirely with equity is an UNLEVERED firm.

Hence, under the NI approach;

Cost of Debt (Kd) = Interest Market Value of Debt

Cost of Equity (Ke) = Earnings available to shareholders Market value of shares outstanding

Value of the firm (V) = Mkt value of Debt + Mkt value of

equity

(V) = D + E

Accordingly, under this approach, the firm’s overall cost of capital or

expected rate of return (WACC) is expressed as;

Cost of capital = Net Operating Income

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Value of firm

Ko = NOI V

On the whole, under this approach, the firm will achieve its maximum

value and minimum WACC (Optimality) when it is 100% Debt

financed.

TRADITIONAL APPROACH

The traditional approach observed that capital structure is relevant

and argued that there is an optimal capital structure and that the

judicious use of debt finance will lead to a reduction in the cost of

capital until an optimum level is reached.

Gearing beyond the optimal level will lead to an increase in

the cost of capital. The argument is that as companies introduces

debt into its capital structure; the WACC will fall due to the theoretical

lower cost of debt compared with equity finance.

As the level of debt increases, the return required by ordinary

shareholders will start to rise due to the following reasons;

The equity provider starts to get worried over the adequacy

of the operating profit to meet the huge debt interest and

still pay dividend.

Equity providers are equally worried over the possibility that

debenture holders can interfere with the management of the

company.

The possibility of the company been forced into liquidation

in the event of failure to meet loan interest payment.

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As the returns required by equity holders increases, WACC

will still continue to fall until it reaches a point where

providers of debt will equally demand for higher returns

because;

A higher level of operating income will be required to meet the

ever increasing debenture interest;

There may be no adequate physical asset to secure additional

loan or debenture.

Graphically, this can be expressed as follows;

Rate Of Return

Ke

Ko

Kd

D/E Optimum = minimum Ko.

WACC decreases up to a certain level of debt and reaching the

minimum level, starts increasing with financial leverage. Optimal

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capital structure is reached where Ko is minimum at which point the

value of the firm is maximised.

Clearly, cost of capital will decrease initially with the use of debt. But

as leverage increases further shareholders start expecting higher risk

premium in the form of increasing cost of equity until a point is

reached at which the advantage of lower cost of debt is more than

offset by more expensive equity.

On the whole, under this approach, capital structure is only relevant

up to the optimal level. This is the point where the cost of debt and

WACC is at its minimum.

M & M HYPOTHESIS WITH TAXES

In their 1963 article, MM showed that capital structure is relevant and

that the value of the firm will increase with debt due to the

deductibility of interest charges for tax computation since leverage

lowers tax payment. Hence, the value of the levered firm will be

higher than that of the unlevered firm.

The interest tax shield/tax advantage is the tax savings that occur on

account of payment of interest to debt holders. The interest tax

shield is a cash inflow to the firm and therefore, it is valuable.

According to them, this interest tax shield can be computed as

follows;

PV of Interest tax shield = (Corporate tax) x ( Interest Rate) Cost of debt

Graphically, this can be shown as follows;

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Clearly, with interest tax shield allowed for levered firms, debt

financing is more advantageous than equity financing. Thus, the

optimum capital structure is reached when the firm employs

almost 100% debt.

FINANCIAL LEVERAGE WITH CORPORATE vs. PERSONAL TAX

Companies pay corporate tax on their earnings. Hence, the earnings

available to investors are reduced by the corporate tax. Further,

investors are required to pay personal taxes on the income earned by

them. Therefore, from the point of view of investors, the effect of

taxes will include both company and personal taxes.

A firm should thus aim at minimizing the effect of total taxes (both

corporate and personal) to investors while deciding about borrowings.

IRRELEVANCE OF CAPITAL STRUCTURE

Two theories established the irrelevance of capital structure. These

are the following;

Net Operating Income Approach

Modigliani and Miller (M&M) without taxes

NET OPERATING INCOME (NOI) APPROACH

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According to this approach popularized by David Durand, the

overall value of the firm and the cost of capital have no relationship

with and are independent of the capital structure and therefore

capital structure is totally irrelevant.

According to the proponent, an increase in debt increases the financial

risk of the shareholders, as they are responsible for the

repayment of the debt. Further increases in leverage will

result in shareholders demanding a higher rate of return on

their investment, hence increasing the cost of equity to a point

that the advantage of cheap debt will be completely wiped out by

the increase in the cost of equity. However, the overall cost of

capital is unaffected and thus remains constant irrespective of the

change in the ratio of debts to equity capital.

Accordingly, the approach decomposed the cost of capital

into two cost elements namely;

(i) The low explicit cost, represented by interest charges on

Debentures/debt and the

(ii) High implicit cost which results from the increase in cost of

equity caused by an increase in the degree of leverage

As a result, the advantage gained in terms of lower cost of

debt (explicit cost) will be neutralized by the disadvantage

in term of high cost of equity (implicit cost). Therefore the cost

of debt and equity will be the same in all capital structures.

With this approach, to obtain the total market value of the firm, the

Net Operating income (NOI) of the firm is capitalized at an

overall rate of return. The market value of debt is then

deducted from the total market value of the firm to obtain the

market value of shares.

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Thus, under this approach;

Value of the Levered firm = Value of Unlevered firm

Value of the firm (VL) = NOIOpportunity cost of capital

Ko = NOI VL

Ke = NOI – Debt. Interest MVe

This approach is based on the assumption that the overall company’s

cost of capital and cost of debt are constant for all degrees of

leverage and the cost of equity increases linearly with that of

leverage, so that the advantage of cheap debt is completely offset by

increasing equity.

Graphically, this can be shown as follow;

KE

Rate Of Return

KO

KD

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Debt/Equity

Overall, under the NOI approach, an optimal capital

structure of a firm does not exist. All capital structures

according to the theory are optimal. The increase in ke is exactly

sufficient to offset the effect of the increased importance of kd so ko

is constant.

MM HYPOTHESIS WITHOUT TAXES

Franco Modigliani and Merton Miller in their original 1958 article

observed that in perfect capital markets without taxes, bankruptcy

and transaction costs, a firm’s market value and the cost of capital

remains invariant to the capital structure changes. The value of

the firm depends on the earnings and risk of its assets

(Business risk) rather than the way in which assets have

been financed.

MM began their proposition by making the following assumptions;

1) All physical assets are owned by the firm

2) Capital markets are frictionless. There are no corporate or

personal Income taxes, securities can be purchased or sold

costlessly and instantaneously.

3) Firms can issue only 2 types of securities, risky equity and

risk free debt.

4) Investors have homogenous expectations about future

stream of profits.

5) All investors have complete knowledge of what

future returns will be.

6) All firms within an industry have the same risk

regardless of capital structure

7) No transactions, agency and bankruptcy costs.

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8) Individuals can borrow or lend as easily and at the

same rate of interest as the firm.

9) All earnings are paid out as dividends. Thus,

earnings are constant and there is no growth.

10) The average cost of capital is constant

Given these assumptions, the MM hypothesis can best be

explained in terms of their 2 propositions as follows;

Proposition I

Proposition II

PROPOSITION I

Consider two firms which are identical (In the same business risk

class, having the same beta and WACC) but different only in their

capital structures. The first firm is unlevered while the other is

levered. M&M argued that the two firms must have

identical total values. If they did not, individual

investors would engage in arbitrage and create

homemade leverage and the market forces that would

drive the two values to be equal.

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To demonstrate this, suppose an investor is considering buying

one of the two firms Unlevered or Levered. Instead of purchasing

the shares of the levered firm, he could purchase the shares of

unlevered firm and borrow the same amount of money B

that the levered firm does. The eventual returns to either of

these investments would be the same. Therefore the price of the

levered firm must be the same as the price of the unlevered

firm minus the money borrowed, which is the value of the

levered firm’s debt.

Essentially, M&M approach is a Net operating Income

approach

because the value of the firm is the capitalized value of NOI. That is;

V = NOI Ko

Since no taxes have been assumed, the operating income (EBIT) is

equivalent to the net income which is all paid out as dividends.

Thus, the value of the firm is equal to;

V = EBIT Ka

Since the value of the firm is equal to the sum of the value of the

debt and equity;

Substituting equation (iii) into (ii), and solving for Ke;

Thus, ke must go up as debt is added to the capital structure.

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%Ke

Ko

Kd

Debt/Equity

Clearly, the basis of MM Proposition I argument is an

arbitrage process and homemade leverage creation.

ARBITRAGE

Arbitrage is the riskless, instantaneous process of buying an asset in

one market at a low price, and then reselling it in another market

where the identical asset is selling at a higher price.

Under the arbitrage process, shareholders can switch

between two firms that are identical in all respects except

their degree of leverage. This means that if one of the firms is

considered highly levered, the investors would sell their shares and

buy those of the unlevered firm. This switching process will

continue until the value of both firms is the same.

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Two (2) types of arbitrage can be distinguished, including;

Real Arbitrage and

Reversed Arbitrage.

REAL ARBITRAGE

Real arbitrage involves the switching by an investor from a levered

firm to an unlevered firm to take advantage of lower risk, increase

in income and sustained income.

For instance, when the value of levered firm is

higher than that of an unlevered firm;

i. An Investor will sell his investment held in that firm

ii. He will borrow propionate to his share of the debt

of the levered firm (at same interest rate)

iii. He will purchase securities of the un-levered firm

equal to his percentage equity holding in the

levered firm

iv. In this switching process, he will earn from the un-

levered firm the same as compare to levered firm

with reduced investment outlay or higher income

as compare to levered firm with full investment

outlay.

REVERSE ARBITRAGE

Reversed arbitrage is the process of switching from an unlevered

firm to a levered firm to take advantage of increase in earnings and

guaranteed constant income.

For instance, when the value of un-levered firm is

higher;

i. An investor will sell his investment held in that firm

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ii. He will buy securities of the levered firm equal to

his percentage holding in un-levered firm (both

equity shares and debt)

iii. In this process he will gain same income as

compare to levered firm with reduced outlay or

higher income as compare to levered firm with full

investment outlay.

On the basis of the arbitrage process, M&M concluded that

the capital structure decision of a firm does not matter and

is therefore IRRELEVANT. Whatever the financing mix adopted,

the market value of the firm remains the same and it does not help

in creating any wealth for shareholders.

HOMEMADE LEVERAGE

Homemade or personal leverage is the idea that as long as

individuals borrow (or lend) at the same rate as the firm, they

can duplicate the effects of corporate leverage on their own. Thus, if

levered firms are priced too high, rational investors will simply

borrow on personal accounts to buy shares in unlevered firms.

It is a technique individual investors can use to synthetically adjust

the leverage of a firm. Basically, in order to replicate the effects of

leverage in the firm, the individual investor borrows money at the

same borrowing rate as the company and adds leverage to his

portfolio.

However, in practice, substituting homemade leverage for corporate

leverage in an individual investor’s portfolio will not reflect

corporate leverage exactly.

PROPOSITION 11

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According to M&M, the cost of equity Ke will increase enough to

offset the advantage of cheaper cost of debt so that the opportunity

cost of capital (Ko) does not change.

M&M Proposition II argued that the value of the firm depends on

three factors including;

i. Required rate of return on the firm's assets (Ke)

ii. Cost of debt of the firm (Kd)

iii. Debt/Equity ratio of the firm (D/E)

The excessive use of debt increases the risk of default. Hence, in

practice, the cost of debt will increase with high level of financial

leverage. MM argued that when Kd increases, Ke will increase at a

decreasing rate and may even turn down eventually.

This proposition can be demonstrated graphically as follows;

A careful perusal of the graph shows that Ke is upward sloping with

a slope of (Ko – Kd). The reason for this behaviour of Ke is

because as a company borrows more debt and increases its

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Debt/Equity ratio, the risk of bankruptcy becomes higher. Since

adding more debt is risky, the shareholders demand a higher rate of

return (Ke) from the firm's business operations.

As leverage (D/E) increases further, Ke continues to increase

but the WACC remains the same even if the company borrows

more debt and increases its Debt/Equity ratio. Ko therefore does not

have any relationship with the D/E ratio. This is the basic identity

of M&M Proposition I and II, that the capital structure of the

firm does not affect its total value.

The conclusion germane from M&M analysis is that capital structure

is irrelevant. Therefore, there is no optimal capital structure for the

firm.

CRITICISMS OF MM IRRELEVANCE HYPOTHESIS

The arbitrage process is the behavioural foundation of MM’s

hypothesis. The arbitrage process may fail to bring equilibrium in

the capital market for the following reasons;

i. Lending and borrowing rate discrepancy.

ii. Non- substitubility of personal and corporate leverage.

iii. Transaction costs exist.

iv. Institutional restrictions.

v. Information asymmetry

vi. Existence of Corporation tax.

Clearly, it is incorrect to assume that Personal leverage is a perfect

substitute for corporate leverage. The existence of limited liability of

firms in contrast with unlimited liability of individuals clearly places

individuals and firms on a different footing in the capital market. In a

levered firm, all investors stand to lose to the extent of the amount

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of the purchase price of their shares. But, if an investor creates

personal leverage, then in the event of the firm’s insolvency, he

would lose not only his principal in the shares of the unlevered firm,

but will also be liable to return the amount of his personal loan.

MM PROVIDED THE FOLLOWING FORMULA

WITH TAXES:

i. Ko = KeVe + KoVo (1 –t) (Ve +Vd) (Ve + Vd)

ii. KEG = Keu + (Keu - Kd)(Vd) (1 - t) (Veg)

Where: Keg = Cost of equity of geared firm Veg = Value of equity of geared firm Keu = Cost of equity of ungeared firm

iii. Kog = kou( 1- V D t ) Vg

iv. Vg = Vu + VDt

WITHOUT TAXES:

i. Ko = KeV e + K d V d (Ve + Vd) (Ve+Vd)

ii. Keg = Keu + (Keu – Kd)(Vd) Ve

iii. Kog = Kou

iv. Vg = Vu

OTHER THEORIES OF CAPITAL STRUCTURE

The following theories discussed below are also associated with the

capital structure of the firm and its optimality.

PECKING ORDER THEORY

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The Pecking Order Theory popularized by Stewart Myers posits

that internal and external funds are used hierarchically. According

to him, businesses adhere to a hierarchy of financing

sources preferring to finance new investment, first internally with

retained earnings, then with debt, and finally with an issue of new

equity.

It maintained that companies prioritize their sources of

financing (from internal financing to equity) according to

the law of least effort, or of least resistance, preferring to

raise equity as a financing means “of last resort”.

Clearly, according to the proponent, equity is a less

preferred means to raise capital.

Trade-Off Theory of Capital Structure

The Trade-Off theory of capital structure was propounded

and popularised by Kraus and Litzenberger. According

to them, optimal capital structure is obtained where the

net tax advantage or benefit of debt financing balances

or equilibrates leverage related costs such as

bankruptcy and agency costs.

It therefore refers to the idea that a company chooses how

much debt finance and how much equity finance to use by

balancing the costs and be nefits.

Clearly, the theory argued that firms usually are financed

partly with debt and partly with equity. It states that there

is an advantage to financing with debt, the tax

benefits of debt and there is a cost of financing with

debt, the costs of financial distress including bankruptcy

and non-bankruptcy costs (e.g. staff leaving, suppliers

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demanding disadvantageous payment terms,

bondholder/stockholder infighting/agency problem, etc).

The marginal benefit of further increases in debt

declines as debt increases, while the marginal cost

increases. Thus a firm that is optimizing its overall value

must focus on this trade-off when choosing how much

debt and equity to use for financing.

Information Asymmetry Theory

The information asymmetry theory of capital structure assumes that

firm managers or insiders possess private information about the

characteristics of the firm’s return stream or investment

opportunities, which is not known to common investors.

REASONS FOR PREFERENCE FOR BORROWING

A number of companies in practice prefer to borrow for the following reasons including;

i. Tax deductibility of interest (tax advantage)

ii. Higher returns to shareholders due to gearing

iii. Complicated procedure for raising equity capital

iv. No dilution of ownership and control

v. Equity results in permanent commitment than debt

OFFSETTING DEMERIT OF DEBT

Several offsetting disadvantages of debt exist in practice. These can

be grouped into the following;

Personal Taxes (investors pay tax on the interest gained)

Financial distress

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Agency problems (conflicts bw DH/SH, SH/MGRS)

PERSONAL TAXES

Personal taxes on interest income reduce the attractiveness of debt.

From the firm’s point of view, there is strong incentive to

borrow, as they will be able to reduce corporate taxes.

However, the advantage of corporate borrowing is reduced by

personal tax loss as investors are required to pay tax on interest.

Thus, the tax saved by the firm is collected in the hands of the

investors.

FINANCIAL DISTRESS

The question to ask here is;

Why do firms tend to avoid very high gearing levels despite

its obvious advantages? One reason is financial distress risk.

Financial distress arises when a firm is not able to meet its

obligations to debt holders. The firm’s continuous failure to make

payments to debt holders can ultimately lead to the insolvency of

the firm.

AGENCY PROBLEMSAgency costs arise because of the conflict between managers

and shareholders interests, on the one hand, and shareholders

and debt holders interests on the other hand. These conflicts give

rise to agency problems, which involves agency costs. The conflict

between shareholders and debt holders arise because of the possibility of

shareholders transferring wealth of debt holders in their favour. Similarly,

the conflict between shareholders and managers arise because

managers may transfer shareholders wealth to their advantage

by increasing their compensation, allowances/ remunerations.

Thus, investors require monitoring and restrictive covenants to

protect their interest.

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FACTORS TO CONSIDER IN DETERMINING CAPITAL

STRUCTURE

The determination of capital structure in practice involves additional

considerations. Important amongst these are:

i. Assets

ii. Issue or floatation

iii. Loan covenants

iv. Early repayment

v. Control dilution

vi. Marketability and timing

vii. Capital market conditions

viii. Capacity of raising funds

ix. Tax benefit of Debt

x. Flexibility

xi. Industry Leverage Ratios

(LEVERAGE=DEBT+EQUITY), Fin Leverage reduces

PAT, after paying tax, profit is reduced

xii. Agency Costs

xiii. Industry Life Cycle

xiv. Degree of Competition

xv. Company Characteristics

xvi. Requirements of Investors

xvii. Timing of Public Issue

xviii. Legal Requirements

LEVERAGE/GEARINGLeverage can be decomposed into two (2) categories as follows;

Financial Leverage

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Operating Leverage

FINANCIAL LEVERAGE

The use of fixed charges sources of funds such as debt and

preference capital along with the owner’s equity in the capital

structure is described as financial leverage or gearing or

trading on equity. The main reason for using financial leverage is

to increase the shareholders returns.

The use of the term trading on equity is derived from the

fact that it is the owners’ equity that is used as the basis to

raise debt; i.e. the equity that is traded upon. The supplier of

the debt has limited participation in the company’s profit and

therefore, he will insist on the protection in earnings and protection

in values represented by owner’s equity.

Financial leverage affects PAT or EPS.

Financial leverage is avoidable, if debt is not introduced into the

firm’s capital structure.

OPERATING LEVERAGE

Operating leverage is the responsiveness of the firm’s EBIT to

changes in sales revenue. It arises from the firm’s use of fixed

operating costs. When the fixed operating costs are present in the

company’s capital structure, changes in sales are magnified into

greater changes in EBIT. Leverage associated with fixed operating

costs.

Operating leverage affects a firm’s operating profit.

COMBINING FINANCIAL AND OPERATING LEVERAGES

Firms use operating and financial leverage in various degrees. The

combined use of operating and financial leverage can be measured

by computing the degree of combined leverage. These combined

effects of two leverages can be quite significant for the earnings

available to ordinary shareholders.

DEGREE OF OPERATING LEVERAGE

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Degree of operating leverage (DOL) is defined as the percentage

change in EBIT relative to a given percentage change in sales. Thus,

DOL = % change in EBIT % change in sales

The following equation can also be used to compute the degree of

operating leverage (DOL) including;

DOL = Contribution EBIT

DOL = Fixed Cost + 1 EBIT

DOL = Q( S-V ) Q(S-V) -F

DOL = VC EBT

DEGREE OF FINANCIAL LEVERAGE (DFL)

Financial leverage affects the EPS. When the economic conditions

are good and the firm’s EBIT is increasing, its EPS increases faster

with more debt in the capital structure. The degree of financial

leverage (DFL) is defined as the % change in EPS due to a

given % change in EBIT. That is;

DFL = % change in EPS % change in EBIT

DFL can also be expressed in any following ways;

DFL = EBIT PBT

DFL = Q(S - V) – F Q(S - V) – F- Interest

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EFFECT OF COMBINED OPERATING AND FINANCIAL

LEVERAGE

Operating and Financial Leverage together can cause wide

fluctuation in EPS for a given change in sales. If a company employs

a high level of operating and financial leverage, even a small

change in the level of sales will have a dramatic effect on EPS.

The degrees of operating and financial leverages can be combined

to observe the effect of total leverage on EPS associated with a

given change in sales.

This can be expressed as;

DCL = DOL +DFL

DCL = Contribution + EBIT = Contribution EBIT PBT PBT

DCL = Q(S-V) X Q(S-V) –F = Q(S-V) Q(S-V)-F Q(S-V)-F-Int Q(S-V)-F-Int

FINANCIAL LEVERAGE AND SHAREHOLDER’S RISK

It has been documented that financial leverage magnifies

shareholders earnings. Also, it is established that the

variability of EBIT causes EPS to fluctuate within wider

ranges with debt in the capital structure. That is, with

more debt, EPS rises and falls faster than the rise and fall in

EBIT. Thus, Financial Leverage not only magnifies EPS but also

increases its variability.

The variability of EBIT and EPS distinguishes between 2

types of risk i ncluding:-

i. Operating/Business risk

ii. Financial risk

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OPERATING/BUSINESS RISK

It is the variability of EBIT associated with a company’s normal

operations. The environment in which a firm operates

determines the variability of EBIT. So long as the environment

is given to the firm, operating risk is an UNAVOIDABLE risk.

Clearly, it arises due to uncertainty of cash flows of the firm’s

investments.

FINANCIAL RISK

Arises on account of the use of debt for financing investments.

A totally equity financed firm will have on financial risks if the

firm decides not to use any debt in its capital structure.

MEASURES OF LEVERAGE/GEARING

The appropriate question to ask here is; ‘How is

Gearing/Leverage measured?’ Clearly, several measures of

leverage exist in the literature including;

i. Income measure

ii. Market value measure

iii. Book value measure

INCOME MEASURE

This measure indicates the capacity of the firm to meet fixed

financial charges. Under here, the level of gearing is measured

by the ratio of fixed interest payment to the company’s total

profit. That is;

Gearing = Fixed Interest Payable Total profit after interest before Tax.

BOOK VALUE MEASURE

Book values are historical figures and when used, may not

reflect current prices. The book value of ordinary shares is the

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sum of share capital, Reserves/Retained Earnings and share

premium

Gearing using Book values can be measured as follows:-

Gearing = Book value of fixed interest security Total Book value of capital (D + E)

MARKET VALUE MEASURE

Market values reflect the current attitude of investors and thus

it is theoretically more appropriate. But it is difficult to get

reliable information on market values in practice. The market

values of securities fluctuate frequently. Market value measure

is expressed as;

Gearing = Market value of fixed interest securityTotal market value of capital (D + E)

FACTORS TO CONSIDER IN DECIDING WHETHER TO USE

EQUITY OR DEBT FINANCE.

In deciding whether to go for equity or debt financing, the

following considerations are important;

a) Dilution of Ownership : If new shares are issued to

new shareholders, it will lead to dilution of control.

Thus if a firm is conscious of retaining control, it can

opt for debt finance.

b) Stability of Earnings: If the company’s earnings are

highly variable, debt finance will increase the

variability and the company’s vulnerability.

c) Security : Issue of debt and the use of debt finance

may require security to be provided by the company.

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d) Tax Savings: Interest paid on debt is a tax allowable

expense, giving rise to savings. A firm desirous of this

savings can opt for debt finance.

e) Financial Risk: Borrowing will introduce financial risk

to the company.

TREATMENT OF PREFERENCE SHARES IN GEARING

Preference shares are difficult to classify. It is often considered

to be a hybrid security since it has many features of both

ordinary shares and debentures.

It is similar to ordinary shares in that;

i. The non payment of dividend does not force the company

into liquidation

ii. Dividends are not deductible for tax purposes and

iii. It has no fixed maturity date.

On the other hand, it is similar to debentures because;

Dividend rate is fixed

Preference shareholders do not share in the residual

earnings

Preference shareholders have claims on income and

assets prior to ordinary shareholders.

They usually do not have voting rights.

Thus, there are two (2) ways to the treatment of this

source of finance. Preference shareholders are regarded as

members of the company during liquidation. Therefore, they

receive no payment until all the creditors have been settled. In

this manner, they are treated just like equity shareholders.

But this type of shareholders equally carries the right to a fixed

dividend and do not share in the residual dividend. In this case,

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it is sappropriate to classify preference shares as a form of

borrowing.

PRACTISE TEASERS ON CAPITAL STRUCTURE

QUESTION 1

A Limited has an expected annual net operating income of

N5,000,000 with a cost of equity of 10% N800,000 8%

debenture.

REQUIRED:

i. Calculate the value of the firm and the company’s cost

of capital.

ii. Assuming that debenture is increased to N1,000,000

while other items remain the same, will the value of

the firm and cost of capital change?

Hint: Assume the Net Income approach.

QUESTION 2

Two firms identical in all respects, one unlevered with N50,000

capital and the other levered with N25,000 10% Debt and

N25,000 equity financing for its operations. Both firms earn

expected return before interest and taxes of N12,500 and will

be liable to pay 30% company tax. The policy of both firms is

to distribute all earnings available and the present value of

interest tax shield for the levered firm.

REQUIRED:

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Determine the value of both firms and ascertain the present

value of interest tax shield.

QUESTION 3

A firm has N500,000 perpetual streams of operating incomes

per annum, with the overall capitalization rate of 16%. The firm

is partially financed by debt of N80,000 at 12%

REQUIRED:

i. Calculate the market value of the firm and cost of

equity.

ii. Suppose the debt increased to N1,000,000 while other

items remain constant, will this affect the value of the

firm and cost of equity

Hint: Assume the Net Operating approach.

QUESTION 4

Rogers Plc. has a geared capital structure with details as

follows:

= Nm =

Value of Debt 200

Value of Equity 300

Total value 500

Existing cost of debt, before taxes 12.50%

Existing cost of equity 20%

Tax rate 40%

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The company proposes to raise N25m of new equity and to use

the money raised to repay N25m of the company’s debt (which

can be assumed to be undated). Assume all earnings are

distributed as either interest or dividend.

REQUIRED:

a) Calculate the existing; (i) WACC (ii) EBIT (iii) Return

required by the ordinary shareholders to compensate

for business risk only.

b) After the change in capital structure, calculate:

i. The company’s total market value

ii. Shareholders wealth

iii. The company’s WACC

iv. The company’s cost of equity.

QUESTION 5

Dangote Cement Plc and Atlas Cement Company are two

publicly quoted companies in the same business risk class.

Each has a constant annual earnings flow (EBIT) of N5m. This

level of earnings is expected to be maintained by both

companies in the future.

Dangote has issued N8m of 9% undated debentures. The

debentures are currently priced to yield 18% per annum. Atlas

cement has no debt. Each of Dangote cement’s 17.2 million

ordinary shares is currently quoted at N1, ex-div while Atlas

has issued 46.4 million shares each of which has a market

price of N0.50, ex-div. Both companies’ payout the entire

earnings flow each years as dividends and interest.

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Foss holds 464,000 shares in Atlas cement as part of her well

diversified investment portfolio. Her market analysis leads her

to believe that Dangote shares are currently under priced

because of a temporary disequilibrium in the market. As a

result, she is considering selling her holdings and investing in

Dangote instead.

REQUIRED:

i) Provide calculations to show that in fact the shares of

Dangote Plc are currently under priced.

ii) Suggest how Foss could undertake Arbitrage deal so

as to maintain her level of financial risk. Explain briefly

why you think your suggested approach will maintain

her financial arise level.

iii) What would be the equilibrium share price of

Dangote’s equity if other investors also undertook

arbitrage deals? Assume that the market prices of the

other securities are in equilibrium.

iv) Explain what is meant by same Business Risk class?

v) What is financial risk and who bears this risk?

QUESTION 6

PMS is a private company with intentions of obtaining a stock

market listing in the near future. The company is wholly equity

financed at present but the Directors are considering a new

capital structure prior to it becoming a listed company.

PMS operates in an industry where the average assets beta is

1.2. The company’s business risk is estimated to be similar to

that of the industry as a whole. The current level of earnings

before interest and taxes is N400,000. This earnings level is

expected to be maintained to the future.

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The rate of return on riskless assets is at present 10% and the

return on the market portfolio is 15%. These rates are post-tax

and are expected to remain constant for the foreseeable

future.

PMS is considering introducing debt into its capital structure by

one of the following methods;

i) N500,000 10% debentures at par, secured on land and

buildings of the company.

ii) N1,000,000 12% unsecured loan stock at par.

The rate of income tax is expected to remain at 33% and

interest on debt is tax deductible.

REQUIRED:

a) Calculate for each of the options;

i. Total market values of the firm

ii. Value of equity

b) List the main problems and costs which might arise for a

company experiencing a period of severe financial

difficulties.

QUESTION 7

The Management of CWAY Ltd. had developed the following

income statement based on an expected sales volume of

100,000 units.

Details = N =

Sales (100,000 units @ N8) 800,000

Variable cost (100,000 @ N4) (400,000)

Contribution 400,000

Fixed costs

(280,000)

EBIT 120,000

REQUIRED

Compute DOL

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QUESTION 8

The profit and loss Account of Alamco plc for the last financial

year was;

N000 N000

Sales 3,600

Variable costs 1440

Fixed costs 960

(2400)

1,200

Interest on Loan finance (400)

PBT 800

Tax rate @ 30% (240)

PAT 560

REQUIRED:

i. Compute the company’s operating leverage?

ii. What is the company’s financial leverage?

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QUESTION 9

A, B, and C Plc are 3 companies in the same line of Business. The abridged Balance

sheets of the companies as at 31/12/03 are below:

Details A plc B plc C plc

Assets

Fixed Assets

Current Assets

Financed By:

Share capital (ord. share of

N1 each

9% Debentures

N000

600

400

1,000

800

200

1,000

N000

500

500

1,000

600

400

1,000

N000

400

600

1,00

0

400

600

1,00

0

It has been observed that the acceptance of the company’s

product lines is identical and will continue to be so in the

future. For the year 2004, the product line acceptance will

either be HIGH, AVERAGE or LOW. If high, each firm’s

operating income will be N120m. An average product line

acceptance will result in N80m operating income while a low

level acceptance is expected to result in N40m operating

income for each company.

REQUIRED:

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a) Assuming a company tax rate of 30%, show the likely

effect of financial leverage on each company’s return

on equity.

b) Comment briefly on the results obtained.

QUESTION 10

AB Ltd needs N1,000,000 for expansion. The expansion is

expected to yield an annual PBIT of N160,000. In choosing a

financial plan, AB Ltd has an objective of maximizing EPS.

It is considering the possibility of issuing equity shares and

raising debt of N100,000 or N400,000 or N600,000. The

current market price per share is N25 and is expected to drop

to N20 if the funds are borrowed in excess of N500,000. Funds

can be borrowed at the rates indicated below;

i. Up to N100,000 @ 8%

ii. Over N100,000 up to N500,000 @ 12%

iii. Over N500,000 @ 18%

REQUIRED:

Determine the EPS of the 3 financing alternatives and suggest

which financing alternative is the best.

QUESTION 11

The following represents the capital structure of Dangote Plc as

at 31/2/06;

= N =

Ord. shares of N1 each 700,000

Capital Reserves 500,000

Revenue Reserve 800,000

2,000,000

9% Debenture 600,000

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15% Debenture 900,000

3,500,000

The current yield on debenture on this risk class is 12%. The

current share price is N5.50k and EPS is N1.10k. The company

is considering an expansion plan which cost N1m and which

will increase earnings by N200,000 per annum for the future

There are 2 possible ways to raise the fund required;

1. An issue of 12% debentures which will increase the

return required by shareholders to 22% to compensate

them for the higher risk due to the increased gearing.

2. An issue of 200,000 new shares of N5 to a consortium

institution. This will reduce the return required by

shareholders to 19% because of reduction in gearing.

REQUIRED:

a) Calculate the capital gearing of the company as at

31/12/06 using the Book value approach.

b) Calculate the gearing of the company using Market value

approach.

c) Explain why the market value approach is more superior.

d) Calculate the capital gearing of the company after the

issue of 1,000,000 debentures using the Market value

approach.

e) Calculate the capital gearing of the company after the

issue of 200,000 ordinary shares using the Market value

approach.

f) Explain how preference shares should be treated in the

calculation of capital gearing.

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QUESTION 12

Two companies, Trinidad and Tobago are both in the same

business risk class but with different capital structure. A

summary of their market value and earnings are given below;

TRINIDAD TOBAGO

=N= =N=

Equity 90,000 50,000

Debts - 50,000

90,000 100,000

EBIT 20,000 20,000

Interest - -- (5000)

Dividend 20,000 15,000

REQUIRED 1. Determine whether or not the two companies are in

equilibrium.

2. An investor holding 5% of the equity of Tobago has

approached you with the following question;

i. Whether he can increase his earnings of the same

investment through arbitrage?

ii. Whether he can hold its earnings constant and

reduce its investment?

Advice him with full details. What conclusions do you

draw?

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