Module 2

Capital Structure
1. Introduction to Capital Structure
The term capital structure refers to the relationship between the various long-term source
financing such as equity capital, preference share capital and debt capital. Deciding the
suitable capital structure is the important decision of the financial management because it is
closely related to the value of the firm.
A company may raise its total capital from various sources such as shares, debentures and
other long term borrowings. There is no fixed charge on equity shares but on preference
shares and debentures it is compulsory to pay dividend or interest respectively. Thus
debentures and preference shares create fixed charge.
Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different long-term sources such as equity shares, preference
shares, debentures, long-term loans and retained earnings.
2. Meaning of Capital Structure
Capital structure is that part of financial structure, which represents long-term sources. The
term, ‘capital structure’ is generally defined to include only long-term debt and total
stockholders’ investment. It is the mix of long-term sources of funds, such as equity shares,
reserves and surpluses, debenture, long-term debt from outside sources and preference share
capital.
To quote Bogen, “Capital structure may consist of a single class of stock, or it may comprise
several issues of bonds and preferred stock, the characteristics of which may vary
considerably”. In other words, capital structure refers to the composition of capitalisation,
i.e., to the proportion between debt and equity that make up capitalisation.
Capital structure is indicated by the following equation:
Capital Structure = Long-term Debt + Preferred Stock + Net worth (or)
Capital Structure = Total Assets – Current Liabilities
Thus, the capital structure of a firm consists of shareholders’ funds and debt. The inherent
financial stability of an enterprise and risk of insolvency to which it is exposed are primarily
dependent on the source of its funds as well as the type of assets it holds and relative
magnitude of such asset’s categories.
The above definitions have given different meanings of capital structure, and not about
optimal capital structure. The following paragraph gives the meaning of optimum capital
structure.
3. Definitions of Capital Structure
Capital structure refers to the mix of a firm’s capitalization i.e., mix of long term sources of
funds such as – debenture, preference share capital, equity share capital and retained earnings
for meeting total capital required.
The term capital structure refers to the relationship between the various long term sources
financing such as equity capital, preference share capital and debt capital.
Capital structure is one of the most vital and complex areas of decision making to any
organization due to its relationship with other financing variable and its closely related to the
value of the firm. Therefore it’s very important for a finance manager to understand the
company’s capital structure and its relationship with returns and wealth maximization.
According to Gerstenbeg, “capital structure of a company refer to the composition or make-
up of its capitalization and it includes all long term capital resources viz., loans, reserve,
share, and bonds.
According to Schwartz, “The capital structure of a business can be measured by the ratio of
various kinds of permanent loan and equity capital to total capital”.
Capitalization, Capital Structure and Financing Structure:
The term capitalization, capital structure and financial structure do not mean the same.
Capitalization
It refers to the quantitative aspect of the financial planning of an enterprise. It refers to the
total amount of capital raised for its long term requirement by share, debenture, borrowing
etc.
Capital structure
capital structure refers to the pattern and the proportion in which the composition of the
capitalization is done.
Financial structure
Financial structure describes the way in which short term and long term assets are included.
Financial structure refers to financial resources and the composition of percentage of short
term and long term sources of funds. Capital structure is a part of financial structure.
4. Concept of Capital Structure
After determining the amount of capitalisation, another component of financial plan is related
to a decision regarding the composition or structure of capital. In other words, a finance
manager has to decide about the make-up of the total amount of capitalisation.
If we look and analyse the balance sheet of any business concern (particularly the company),
we find that its total capital is being distributed in equity shares, preference shares and
debentures or bonds. Normally, the proportionate relationship between these securities is
known as Capital Structure. However, financial experts differ in respect of composition of
capital structure.
For example, Richard C. Osborn defines capital structure “as the financial plan according to
which all assets of a company are financed. This capital is supplied by long-term and short-
term borrowings, the sale of preferred and common (equity) stock (shares) and reinvestment
of earnings.”
A similar view is also expressed by Walker and Baughn when they opine that the capital
structure is synonymous with total capital; this term refers to the make-up of the credit side of
the balance sheet or the division of claims among trade creditors, bank creditors, bond-
holders, stock-holders, etc.
In contrast, Guthman and Dougall state that the phrase ‘capital structure’ may be used to
cover the total combined investment of bond-holders including long-term debts such as
mortgages and long-term loans as well as total stock-holders investment including retained
earnings as well as original investment. Thus, the term capital structure refers to the
composition of the long-term sources of funds.
It includes equity capital including retained earnings and long-term debts. Thus, short-term
liabilities should be excluded from the formulation of capital structure. In a simple way,
capital structure is used to represent the proportionate relationship between debt and equity.
In other words, capital structure represents in what proportion the total amount of
capitalisation is divided in different securities.
Capital structure is the mix of long-term sources and it includes owned capital, preference
share capital and long-term debt capital. Owned capital is known as variable dividend
security, preference share capital is considered as fixed-dividend security and
debentures/bonds/long-term debts are known as fixed interest bearing securities.
The Financial Manager attempts to fix the proportion/ratio among all these securities on the
basis of certain assumptions and with reference to particular situation. While determining the
pattern of capital structure or capital mix, a number of factors are to be considered.
However, the capital structure must be one which may protect the owners’ interest by
assuring an optimal return continuously. The capital structure which offers guarantee for
optimum returns is called optimum capital structure.
But the determination of such an optimum capital structure is a formidable task in practice.
That is why significant variations among industries and among different individual
companies within an industry regarding capital structure are noted.
A number of factors like features of individual securities, average cost of each source, form
of control over the concern, extent of risks involved, etc., influence the capital structure
decision.
5. Features of an Appropriate Capital Structure
The appropriate capital structure is designed in such a way that the balance is made between
return, risk and control of the firm.
The following are main features of an appropriate capital structure:
1. Financial Leverage:
The appropriate capital structure should maximise the return on stocks. The return can be
maximised by having the proper mix of debt and equity capital in the capital structure of the
firm. The debt is the cheapest source of funds. Thus, by increasing the proportion of debt in
the capital of the firm, return on stocks can be increased.
However, the use of debt in capitalisation will depend on expected profits of the firm.
Financial risk factor is involved in the use of debt in the total capital of a firm. If profits are
low, lower proportion of debt should be used so that interest burden on the firm does not pose
a threat to the existence of the firm.
If profits are high, a higher level of debt can be used to maximise the earnings on shares. This
will serve the objective of finance manager i.e., to maximise the wealth of shareholders.
2. Financial Risk:
The capital structure of a firm should provide maximum return to equity shareholders at the
minimum financial risk. As the degree of financial leverage increases, the financial risk
increases in a firm. Financial risk increases in tandem to increased use of debt in the capital
structure of the firm.
A firm can use debt in a larger proportion in the capital structure of a firm, if the level of
expected profits is high. Otherwise, debt should be used in small proportion in the capital of a
firm. An appropriate capital structure should strike a balance between financial risk and
return.
3. Ownership Control:
If management wants to keep the control of the firm in a few hands, then a larger proportion
of the capital should be raised by debt capital. The increasing proportion of debt will not
dilute the control of the firm. The appropriate capital structure should maintain a proper mix
of debt and equity capital so that management of the firm can function in the democratic way.
4. Flexibility in Raising Funds:
The capital structure of a firm should be flexible. It should have some financial slack. The
capital structure should provide a room for expansion or starting of new projects by raising
debt and equity capital when need arises. An appropriate capital structure of a firm should
have the scope for raising funds as need arises.
Thus, an appropriate capital structure should be such as to maximise the returns on stock at
the minimum level of financial risk. Further, there should be scope for expansion of business
by raising the capital as when required. The capital structure of a firm should not pose risk to
ownership control.
6. Importance of Capital Structure
Capital structure decision is one of the strategic decisions taken by the financial management.
Considerable attention is required to decide the mix up of various sources of finance. A
judicious and right capital structure decision reduces the cost of capital and increases the
value of a firm while a wrong decision can adversely affect the value of the firm.
Various sources of finance differ in terms of risk and cost. Hence, there is utmost need of
designing an appropriate capital structure.
Capital structure decisions are of great significance due to the following reasons:
(i) Capital structure determines the risk assumed by the firm.
(ii) Capital structure determines the cost of capital of the firm.
(iii) It affects the flexibility and liquidity of the firm,
(iv) It affects the control of owners of the firm.
7. Capital Structure Decision
A company’s financing decision or capital structure decision is concerned with the sources of
funds from where long term finance is raised and the proportion in which the total amount is
raised using these sources of funds. It involves determining how the selected assets / project
will be financed.
Broadly, financing decisions involve the following three issues:
i. The amount of total long term capital requirement. This is related to the capital budgeting
decision of the company.
ii. Sources of funds from where funds are raised.
iii. Composition of total funds i.e. the proportion of each specific source in total
capitalization.
8. Patterns of Capital Structure
Firm’s capital structure may be arrived at by use of equity share capital or preference share
capital or debt capital (debentures or loans) or combination of all of them. The use of any one
of these sources does not help come up with an optimum capital structure. Construction of
optimum capital structure is possible only when there is an appropriate mix of the above
sources (debt and equity).
The following are the patterns of capital structure:
(i) Complete equity share capital.
(ii) Different proportions of equity and preference share capital.
(iii) Different proportions of equity and debenture (debt) capital and.
(iv) Different proportions of equity, preference and debenture (debt) capital.
Approaches to Determine Appropriate Capital Structure:
The following are the approaches available to determine a firm’s capital structure:
1. EBIT-EPS Approach – This approach is helpful to analyse the impact of debt on earnings
per share.
2. Valuation Approach – It determines the impact of use of debt on the shareholders value and
3. Cash Flow Approach – It analyses the firm’s debt service capacity.
Apart from the above ROI-ROE analysis, ratio analysis is also used. But here we will discuss
the EBIT-EPS approach.
EBIT-EPS (Approach) Analysis:
Leverage affects shareholders’ return and risk that has been under leverages. But here we
shall understand how sensitive is earnings per share (EPS) to the changes in earnings before
interest and tax (EBIT) under different financial plans/capital structures. It is known as EBIT-
EPS analysis. Use of fixed cost sources of finance in the capital structure of a firm is known
as financial leverages or trading on equity.
The benefits are more when a firm uses debt as a source of finance, due to cheap and the
interest is tax deductible source. Use of debt can be used to maximise shareholders’ wealth
only when a firm has a high level of operating profit (EBIT). EBIT-EPS analysis is one way
to study the relation between earnings per share (EPS) and various possible levels of
operating profit (EBIT), under various financial plans.
Illustration:
VS International Ltd., has a capital structure (all equity) comprising Rs.5,00,000 each share
of Rs.10. The firm wants to raise an additional Rs.2,50,000 for expansion programme. The
firm has four alternative financial plans I, II, III and IV. If the firm is able to earn an operating
profit at Rs.80,000 after additional investment and 50 per cent tax rate. Calculate EPS for all
four alternatives and select the preferable financial plan.
Financial plans:
I. Raise the entire amount by issue of new equity capital.
II. Raise 50 per cent as equity capital and 50 per cent as 10 per cent debt capital.
III. Raise the entire amount as 12 per cent debentures.
IV. Raise 50 per cent equity capital and 50 per cent preference share capital at 10 per cent.
Solution:

Financial Plan II is preferable since EPS in that plan is high when compared to others.
9. Factors Influencing Capital Structure
1. Internal factors.
2. External factors.
1. Internal Factors:
(i) Financial Leverage:
The use of fixed interest bearing securities, such as – debt and preference capital along with
owner’s equity in the capital structure is described as – ‘financial leverage’ or ‘trading on
equity’. This decision is most important from the point of view of financing decisions.
By having debt and equity in the capital mix, the company will have an opportunity to
employ a certain amount of debt with an intention to enjoy the benefits of reduction in
percentage of tax. The benefits so enjoyed will be passed to the equity shareholders in the
form of a high percentage of dividend.
(ii) Risk:
Debt securities increase the financial risk while equity securities reduce it. A firm can avoid
or reduces risk if it does not employ debt capital mix, but compromising with the returns to
equity shareholder. Hence a financial manager must employ the debt capital in such a way
that the benefits of that should maximize the returns to equity shareholders.
(iii) Growth and Stability:
In the initial stages, a firm meets its financial requirements through long term sources like
equity. Once the company starts getting good response and cash inflow capacity increases, it
can raise debt or preference capital for growth and expansion.
The company having high sales will opt for more debt for their financial requirements. A
company having less sales revenue must reduce its burden towards debt, because of its
inability to pay interest on debt.
(iv) Retaining Control:
The attitude of the management towards retaining the control over the company will have a
direct impact on the capital structure. If the existing shareholder wants to continue the same
holding on the company, they may not encourage the issue of additional equity shares.
In normal practical situations, the existing equity shareholder directs the management to raise
the additional sources only through debentures or preference shares which are also influenced
by the reputation that the company enjoys.
(v) Cost of Capital:
The cost of capital refers to the expectation of the suppliers of funds. A firm should earn
sufficient profits to repay the interest and installment of principal to the lenders. It is the
maximum rate of return a firm should earn on its investment, so that market value of the
shares of the company does not fall.
Different types of sources of funds will have different types of costs. Comparatively debt is a
cheaper source of funds. Careful decisions have to be made in selecting the size of debt as it
increases the risk of the firm.
(vi) Cash Flow:
Cash flow generation capacity of a firm increases the flexibility of the financial manager in
deciding the capital structure. Sound cash flow facilitates the raising of funds through debt,
insufficient cash takes a company to a disastrous situation, it loses its creditworthiness and
many times goes into liquidation. Yearly cash inflow matters much to decide the capacity of a
company to borrow debt.
(vii) Flexibility:
It means the firm’s ability to adopt its structure to the needs of the changing conditions; its
capital structure should be flexible so that without much practical difficulty, a firm can
change the securities in capital structure. It mainly depends on flexibility in fixed charges,
restrictive covenants, terms of redemption and the debt capacity.
(viii) Purpose of Finance:
The purpose of finance influences the capital structure. If a firm is engaged in a business
transaction, it can make use of debt and equity mix or can enjoy leverage benefits. For non-
profit organization funds may be raised through only equity. For existing company’s growth
and expansion may be financed through retained earnings, debenture or preference capital.
(ix) Assets Structure:
Fixed assets investment can be met by longer sources like issue of equity, debenture etc. A
portion of current assets are also financed through long term sources, short term sources are
used for meeting the working capital requirement.
2. External Factors:
(i) Size of the Company:
If a company plans to raise a smaller amount of capital, it selects only few securities in its
capital structure. If it needs more capital, a number of different securities will be selected to
raise funds in the capital structure.
(ii) Factor of Industry:
A public utility company which has support from state and central government can raise
funds through preference share or debenture. A capital intensive company engaged in
manufacture may have high equity and less debt capital. A trading company having less
assets structure has to depend mainly on equity or preference capital.
(iii) Investors:
Investors are cautious over all the investments. Capital market is moving from equity to debt
and from debt to deep discount bonds. The finance manager must be careful in selecting the
securities for capital structure.
(iv) Cost of Flotation:
It refers to the expenses of a firm incurred during the process of public issue. Cost of flotation
of debt is comparatively less when compared to the cost of flotation of equity. One should try
to reduce this cost by a proper mix of debt and equity in the capital structure.
(v) Legal Requirements:
The legal and statutory requirements of the government, SEBI guidelines on investor
protection, equity ratio, promoter’s contributions etc., will have direct bearing on capital
structure and also monetary and fiscal policies of the government.
(vi) Period of Finance:
Short term funds, required to meet working capital requirements can be raised through
commercial banks. Medium term finance, required to meet expansion and diversification
purpose, can be raised through issue of preference or debenture capital- Long term or
permanent funds required to meet capital expenditure can be raised by issuing equity shares.
(vii) Lever of Interest Rate:
The rate of interest will have a direct impact on borrowed funds. If the expectation of the
banker or financial institutions is to get a high rate of interests then the firm can postpone the
mobilization of funds or make use of retained earnings. Hence it affects the capital structures.
(viii) Lever of Business Activity:
When the level of activity of a firm is rising, the additional funds required for expansion and
diversification can be raised through issue of debentures, preference shares or borrowing
terms loans.
(ix) Availability of Funds:
Free flow of money in the economy encourages a corporate to raise funds through securities
without much difficulty. The finance manager has to study the flow and availability of funds
before he decides about the capital structure.
(x) Taxation Policy:
High corporate taxes. Taxes on dividend and capital gains directly influenced the decision of
capital structure. High taxes discourage the issue of equity and encourage issuing more debt
instruments.
(xi) Level of Stock Prices:
If the general price level of stocks or raw material is constant over a period of time,
management prefers to invest such funds through long term or medium term financing. If the
prices are fluctuating widely Short term sources are the best alternative for investments.
10 .Financial Structure
Financial structure of a company is concerned with both long term and short term sources of
funds. Hence financial structure is the mix of all sources of funds whether long term such as
debt and equity or short term such as bank overdraft, short term loans etc.
11. Capital Gearing
Capital gearing has great importance in maintaining a strong financial position and organised
capital structure of a company. Capital gearing is defined as a ratio between equity share
capital and fixed cost capital bearing securities i.e., long-term debts, debentures and
preference share capital.
The formula is as follows:
Capital Gearing Ratio = (Equity Share Capital + Reserves and Surplus)/(Preference Share
Capital + Interest bearing Finance)
Definitions:
According to J. Batty, “The relation of ordinary share to preference share capital and loan
capital is described as the Capital gearing.”
According to Brown and Howard, “The term Capital gearing is used to describe the ratio
between the ordinary share capital and interest bearing securities of a company.”
Types of Capital Gearing:
1. High Gearing:
When the ratio of fixed interest bearing securities, debentures, preference share capital, long-
term debts etc., is more than equity share capital in the total capital of the company, it is
known as high gearing. For example, the total capital of the company is Rs.1 crore out of this
company collected Rs.25 lakh through issue of equity shares, Rs.20 lakh through issue of
10% preference shares and Rs.55 lakh through 8% debentures.
Thus capital gearing ratio will be:
25,00,000/(20,00,000 + 55,00,000) = 1:3 (High Gearing)
2. Low Gearing:
Low gearing is just opposite to the high gearing in the case of low gearing the ratio of
ordinary share capital is comparatively more than the fixed interest bearing securities,
debentures, preference share capital, long-term debts etc.
For example, the total capital of the company is Rs.1 crore out of this company collected
Rs.60 lakh through issue of equity shares, Rs.20 lakh through issue of 10% preference shares
and Rs.20 lakh through 8% debentures.
Thus capital gearing ratio will be:
60,00,000/(20,00,000 + 20,00,000) = 3:2 (Low Gearing)
Importance of Capital Gearing:
An optimum capital structure can be framed with the help of capital gearing. Usually in the
beginning, a company should follow the policy of low capital gearing, and as the business
and profits grow in future the policy of high capital gearing should be adopted. In fact a
balanced and overall capital gearing is very helpful in successful operation of a business
concern.
Effect of Capital Gearing during Trade Cycles:
1. Effect during Inflation or Boom Period:
During inflationary conditions a company can adopt high gearing and can increase the rate of
dividend for equity shareholders. In this period fixed interest bearing capital is used more and
more as the profits increased considerably.
In fact during the boom period the rate of interest or dividend payable on fixed cost securities
is much lower than the rate of profitability. Therefore a company can manage to pay
dividends to its equity shareholders at higher rates.
2. Effect during Deflation or Depression Period:
During the deflation period a company should adopt the policy of low gearing and should
issue variable cost bearing capital i.e., equity share capital more and more. In this period the
profits of the company fall and the rate of interest increases, hence a company will not be
able to pay fixed interest cost out of the profit available. So a company should not issue the
fixed cost capital but should prefer to maintain low gearing by issuing more and more equity
share capital.
At the end it may be said without any doubt that all the policies regarding capital structure
and financial management or administration of capital depends only on the balanced capital
gearing.
Illustration:
The capital structure of two companies X and Y is as under:

12. Capital Structure Theories

What is the relationship between capital structure, cost of capital and Company’s value?
There are different theories to answer this question. One school of thought firmly believes
that there is a relationship between value of the company and its overall cost of capital.
However according to another school of thought there is no relationship between the value of
company and its overall cost of capital. Remember, overall cost of capital is the outcome of
capital structure.
The following approaches are generally followed for examining the relationship between
the value of company and its capital structure:
1. Net Income approach (N.I.)
2. Net Operating Income approach (N.O.I.)
3. Modiglliani-Miller approach (M.M.)
4. Traditional approach (T)
Before we take each approach separately for discussion, let us mention the basic assumptions
regarding capital structure theories.
These assumptions are:
(i) There are only two sources of finances, viz., perpetual riskless debt and equity shares.
(ii) Corporate taxes are not in vogue.
(iii) Entire earnings are distributed as dividends i.e., dividend payout ratio is 100 percent.
(iv) In view of (iii) above, there are no retained earnings.
(v) The operating profit of the company is given and is not expected to grow.
(vi) All investors have the same subjective probability distribution of the expected future
earnings before interest and taxes for a given company.
(vii) Total assets of a company are given and these are not expected to change over a period
of time.
(viii) The company has a perpetual life.
(ix) Business risk is constant over time and it is independent of its capital structure and
financial risk.
Before going into further discussion, the following formula should be taken into
account:

13. Optimal/Optimum Capital Structure

In a financing decision, a financial manager’s job is to come out with an optimum capital
structure. Optimum capital structure is that capital structure at that level of debt – equity
proportion where the market value per share is maximum and the cost of capital is minimum.
The same to quote, Ezra, optimum leverage is that mix of debt and equity which will
maximise the market value of the company and minimise the company’s overall cost of
capital.
The study of capital structure involves a discussion of the nature of the industry and specific
circumstances of the business enterprise in question besides the general theory of finance. It
is difficult to define ideal capital structure.
A company’s capital structure is a function of the nature of its business and how risky the
particular business is and therefore, a matter of business judgment.
As observed by Van Home, “In the optimum capital structure, the marginal real cost of each
available method of financing is the same”. As Guthmann and Dougall rightly remark, from a
strictly financial point of view, the optimum capital structure is achieved by balancing the
financing so as to achieve the lowest average cost of long-term funds. This in turn produces
that maximum market value for the total securities issued against a given amount of corporate
income.
The optimum capital structure keeps a balance between share capital and debt capital. The
primary reason for the employment of debt by an enterprise can be stated as that up to a
certain point, debt is from the point of view of the ownership, a less expensive source of
funds than equity capital. Hence, optimum capital structure keeps a balance between debt
capital and equity capital.
14. Difference between Capital Structure and Capitalization
The important differences between Capital Structure & Capitalization are as under:

15. Differences between Capital Structure and Financial Structure

The important differences between Capital structure & financial structure are as
under:
Capital Structure
1. Introduction to Capital Structure
The term capital structure refers to the relationship between the various long-term source
financing such as equity capital, preference share capital and debt capital. Deciding the
suitable capital structure is the important decision of the financial management because it is
closely related to the value of the firm.
A company may raise its total capital from various sources such as shares, debentures and
other long term borrowings. There is no fixed charge on equity shares but on preference
shares and debentures it is compulsory to pay dividend or interest respectively. Thus
debentures and preference shares create fixed charge.
Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different long-term sources such as equity shares, preference
shares, debentures, long-term loans and retained earnings.
2. Meaning of Capital Structure
Capital structure is that part of financial structure, which represents long-term sources. The
term, ‘capital structure’ is generally defined to include only long-term debt and total
stockholders’ investment. It is the mix of long-term sources of funds, such as equity shares,
reserves and surpluses, debenture, long-term debt from outside sources and preference share
capital.
To quote Bogen, “Capital structure may consist of a single class of stock, or it may comprise
several issues of bonds and preferred stock, the characteristics of which may vary
considerably”. In other words, capital structure refers to the composition of capitalisation,
i.e., to the proportion between debt and equity that make up capitalisation.
Capital structure is indicated by the following equation:
Capital Structure = Long-term Debt + Preferred Stock + Net worth (or)
Capital Structure = Total Assets – Current Liabilities
Thus, the capital structure of a firm consists of shareholders’ funds and debt. The inherent
financial stability of an enterprise and risk of insolvency to which it is exposed are primarily
dependent on the source of its funds as well as the type of assets it holds and relative
magnitude of such asset’s categories.
The above definitions have given different meanings of capital structure, and not about
optimal capital structure. The following paragraph gives the meaning of optimum capital
structure.
3. Definitions of Capital Structure
Capital structure refers to the mix of a firm’s capitalization i.e., mix of long term sources of
funds such as – debenture, preference share capital, equity share capital and retained earnings
for meeting total capital required.
The term capital structure refers to the relationship between the various long term sources
financing such as equity capital, preference share capital and debt capital.
Capital structure is one of the most vital and complex areas of decision making to any
organization due to its relationship with other financing variable and its closely related to the
value of the firm. Therefore it’s very important for a finance manager to understand the
company’s capital structure and its relationship with returns and wealth maximization.
According to Gerstenbeg, “capital structure of a company refer to the composition or make-
up of its capitalization and it includes all long term capital resources viz., loans, reserve,
share, and bonds.
According to Schwartz, “The capital structure of a business can be measured by the ratio of
various kinds of permanent loan and equity capital to total capital”.
Capitalization, Capital Structure and Financing Structure:
The term capitalization, capital structure and financial structure do not mean the same.
Capitalization
It refers to the quantitative aspect of the financial planning of an enterprise. It refers to the
total amount of capital raised for its long term requirement by share, debenture, borrowing
etc.
Capital structure
capital structure refers to the pattern and the proportion in which the composition of the
capitalization is done.
Financial structure
Financial structure describes the way in which short term and long term assets are included.
Financial structure refers to financial resources and the composition of percentage of short
term and long term sources of funds. Capital structure is a part of financial structure.
4. Concept of Capital Structure
After determining the amount of capitalisation, another component of financial plan is related
to a decision regarding the composition or structure of capital. In other words, a finance
manager has to decide about the make-up of the total amount of capitalisation.
If we look and analyse the balance sheet of any business concern (particularly the company),
we find that its total capital is being distributed in equity shares, preference shares and
debentures or bonds. Normally, the proportionate relationship between these securities is
known as Capital Structure. However, financial experts differ in respect of composition of
capital structure.
For example, Richard C. Osborn defines capital structure “as the financial plan according to
which all assets of a company are financed. This capital is supplied by long-term and short-
term borrowings, the sale of preferred and common (equity) stock (shares) and reinvestment
of earnings.”
A similar view is also expressed by Walker and Baughn when they opine that the capital
structure is synonymous with total capital; this term refers to the make-up of the credit side of
the balance sheet or the division of claims among trade creditors, bank creditors, bond-
holders, stock-holders, etc.
In contrast, Guthman and Dougall state that the phrase ‘capital structure’ may be used to
cover the total combined investment of bond-holders including long-term debts such as
mortgages and long-term loans as well as total stock-holders investment including retained
earnings as well as original investment. Thus, the term capital structure refers to the
composition of the long-term sources of funds.
It includes equity capital including retained earnings and long-term debts. Thus, short-term
liabilities should be excluded from the formulation of capital structure. In a simple way,
capital structure is used to represent the proportionate relationship between debt and equity.
In other words, capital structure represents in what proportion the total amount of
capitalisation is divided in different securities.
Capital structure is the mix of long-term sources and it includes owned capital, preference
share capital and long-term debt capital. Owned capital is known as variable dividend
security, preference share capital is considered as fixed-dividend security and
debentures/bonds/long-term debts are known as fixed interest bearing securities.
The Financial Manager attempts to fix the proportion/ratio among all these securities on the
basis of certain assumptions and with reference to particular situation. While determining the
pattern of capital structure or capital mix, a number of factors are to be considered.
However, the capital structure must be one which may protect the owners’ interest by
assuring an optimal return continuously. The capital structure which offers guarantee for
optimum returns is called optimum capital structure.
But the determination of such an optimum capital structure is a formidable task in practice.
That is why significant variations among industries and among different individual
companies within an industry regarding capital structure are noted.
A number of factors like features of individual securities, average cost of each source, form
of control over the concern, extent of risks involved, etc., influence the capital structure
decision.
5. Features of an Appropriate Capital Structure
The appropriate capital structure is designed in such a way that the balance is made between
return, risk and control of the firm.
The following are main features of an appropriate capital structure:
1. Financial Leverage:
The appropriate capital structure should maximise the return on stocks. The return can be
maximised by having the proper mix of debt and equity capital in the capital structure of the
firm. The debt is the cheapest source of funds. Thus, by increasing the proportion of debt in
the capital of the firm, return on stocks can be increased.
However, the use of debt in capitalisation will depend on expected profits of the firm.
Financial risk factor is involved in the use of debt in the total capital of a firm. If profits are
low, lower proportion of debt should be used so that interest burden on the firm does not pose
a threat to the existence of the firm.
If profits are high, a higher level of debt can be used to maximise the earnings on shares. This
will serve the objective of finance manager i.e., to maximise the wealth of shareholders.
2. Financial Risk:
The capital structure of a firm should provide maximum return to equity shareholders at the
minimum financial risk. As the degree of financial leverage increases, the financial risk
increases in a firm. Financial risk increases in tandem to increased use of debt in the capital
structure of the firm.
A firm can use debt in a larger proportion in the capital structure of a firm, if the level of
expected profits is high. Otherwise, debt should be used in small proportion in the capital of a
firm. An appropriate capital structure should strike a balance between financial risk and
return.
3. Ownership Control:
If management wants to keep the control of the firm in a few hands, then a larger proportion
of the capital should be raised by debt capital. The increasing proportion of debt will not
dilute the control of the firm. The appropriate capital structure should maintain a proper mix
of debt and equity capital so that management of the firm can function in the democratic way.
4. Flexibility in Raising Funds:
The capital structure of a firm should be flexible. It should have some financial slack. The
capital structure should provide a room for expansion or starting of new projects by raising
debt and equity capital when need arises. An appropriate capital structure of a firm should
have the scope for raising funds as need arises.
Thus, an appropriate capital structure should be such as to maximise the returns on stock at
the minimum level of financial risk. Further, there should be scope for expansion of business
by raising the capital as when required. The capital structure of a firm should not pose risk to
ownership control.
6. Importance of Capital Structure
Capital structure decision is one of the strategic decisions taken by the financial management.
Considerable attention is required to decide the mix up of various sources of finance. A
judicious and right capital structure decision reduces the cost of capital and increases the
value of a firm while a wrong decision can adversely affect the value of the firm.
Various sources of finance differ in terms of risk and cost. Hence, there is utmost need of
designing an appropriate capital structure.
Capital structure decisions are of great significance due to the following reasons:
(i) Capital structure determines the risk assumed by the firm.
(ii) Capital structure determines the cost of capital of the firm.
(iii) It affects the flexibility and liquidity of the firm,
(iv) It affects the control of owners of the firm.
7. Capital Structure Decision
A company’s financing decision or capital structure decision is concerned with the sources of
funds from where long term finance is raised and the proportion in which the total amount is
raised using these sources of funds. It involves determining how the selected assets / project
will be financed.
Broadly, financing decisions involve the following three issues:
i. The amount of total long term capital requirement. This is related to the capital budgeting
decision of the company.
ii. Sources of funds from where funds are raised.
iii. Composition of total funds i.e. the proportion of each specific source in total
capitalization.
8. Patterns of Capital Structure
Firm’s capital structure may be arrived at by use of equity share capital or preference share
capital or debt capital (debentures or loans) or combination of all of them. The use of any one
of these sources does not help come up with an optimum capital structure. Construction of
optimum capital structure is possible only when there is an appropriate mix of the above
sources (debt and equity).
The following are the patterns of capital structure:
(i) Complete equity share capital.
(ii) Different proportions of equity and preference share capital.
(iii) Different proportions of equity and debenture (debt) capital and.
(iv) Different proportions of equity, preference and debenture (debt) capital.
Approaches to Determine Appropriate Capital Structure:
The following are the approaches available to determine a firm’s capital structure:
1. EBIT-EPS Approach – This approach is helpful to analyse the impact of debt on earnings
per share.
2. Valuation Approach – It determines the impact of use of debt on the shareholders value and
3. Cash Flow Approach – It analyses the firm’s debt service capacity.
Apart from the above ROI-ROE analysis, ratio analysis is also used. But here we will discuss
the EBIT-EPS approach.
EBIT-EPS (Approach) Analysis:
Leverage affects shareholders’ return and risk that has been under leverages. But here we
shall understand how sensitive is earnings per share (EPS) to the changes in earnings before
interest and tax (EBIT) under different financial plans/capital structures. It is known as EBIT-
EPS analysis. Use of fixed cost sources of finance in the capital structure of a firm is known
as financial leverages or trading on equity.
The benefits are more when a firm uses debt as a source of finance, due to cheap and the
interest is tax deductible source. Use of debt can be used to maximise shareholders’ wealth
only when a firm has a high level of operating profit (EBIT). EBIT-EPS analysis is one way
to study the relation between earnings per share (EPS) and various possible levels of
operating profit (EBIT), under various financial plans.
Illustration:
VS International Ltd., has a capital structure (all equity) comprising Rs.5,00,000 each share
of Rs.10. The firm wants to raise an additional Rs.2,50,000 for expansion programme. The
firm has four alternative financial plans I, II, III and IV. If the firm is able to earn an operating
profit at Rs.80,000 after additional investment and 50 per cent tax rate. Calculate EPS for all
four alternatives and select the preferable financial plan.
Financial plans:
I. Raise the entire amount by issue of new equity capital.
II. Raise 50 per cent as equity capital and 50 per cent as 10 per cent debt capital.
III. Raise the entire amount as 12 per cent debentures.
IV. Raise 50 per cent equity capital and 50 per cent preference share capital at 10 per cent.
Solution:
Financial Plan II is preferable since EPS in that plan is high when compared to others.
9. Factors Influencing Capital Structure
1. Internal factors.
2. External factors.
1. Internal Factors:
(i) Financial Leverage:
The use of fixed interest bearing securities, such as – debt and preference capital along with
owner’s equity in the capital structure is described as – ‘financial leverage’ or ‘trading on
equity’. This decision is most important from the point of view of financing decisions.
By having debt and equity in the capital mix, the company will have an opportunity to
employ a certain amount of debt with an intention to enjoy the benefits of reduction in
percentage of tax. The benefits so enjoyed will be passed to the equity shareholders in the
form of a high percentage of dividend.
(ii) Risk:
Debt securities increase the financial risk while equity securities reduce it. A firm can avoid
or reduces risk if it does not employ debt capital mix, but compromising with the returns to
equity shareholder. Hence a financial manager must employ the debt capital in such a way
that the benefits of that should maximize the returns to equity shareholders.
(iii) Growth and Stability:
In the initial stages, a firm meets its financial requirements through long term sources like
equity. Once the company starts getting good response and cash inflow capacity increases, it
can raise debt or preference capital for growth and expansion.
The company having high sales will opt for more debt for their financial requirements. A
company having less sales revenue must reduce its burden towards debt, because of its
inability to pay interest on debt.
(iv) Retaining Control:
The attitude of the management towards retaining the control over the company will have a
direct impact on the capital structure. If the existing shareholder wants to continue the same
holding on the company, they may not encourage the issue of additional equity shares.
In normal practical situations, the existing equity shareholder directs the management to raise
the additional sources only through debentures or preference shares which are also influenced
by the reputation that the company enjoys.
(v) Cost of Capital:
The cost of capital refers to the expectation of the suppliers of funds. A firm should earn
sufficient profits to repay the interest and installment of principal to the lenders. It is the
maximum rate of return a firm should earn on its investment, so that market value of the
shares of the company does not fall.
Different types of sources of funds will have different types of costs. Comparatively debt is a
cheaper source of funds. Careful decisions have to be made in selecting the size of debt as it
increases the risk of the firm.
(vi) Cash Flow:
Cash flow generation capacity of a firm increases the flexibility of the financial manager in
deciding the capital structure. Sound cash flow facilitates the raising of funds through debt,
insufficient cash takes a company to a disastrous situation, it loses its creditworthiness and
many times goes into liquidation. Yearly cash inflow matters much to decide the capacity of a
company to borrow debt.
(vii) Flexibility:
It means the firm’s ability to adopt its structure to the needs of the changing conditions; its
capital structure should be flexible so that without much practical difficulty, a firm can
change the securities in capital structure. It mainly depends on flexibility in fixed charges,
restrictive covenants, terms of redemption and the debt capacity.
(viii) Purpose of Finance:
The purpose of finance influences the capital structure. If a firm is engaged in a business
transaction, it can make use of debt and equity mix or can enjoy leverage benefits. For non-
profit organization funds may be raised through only equity. For existing company’s growth
and expansion may be financed through retained earnings, debenture or preference capital.
(ix) Assets Structure:
Fixed assets investment can be met by longer sources like issue of equity, debenture etc. A
portion of current assets are also financed through long term sources, short term sources are
used for meeting the working capital requirement.
2. External Factors:
(i) Size of the Company:
If a company plans to raise a smaller amount of capital, it selects only few securities in its
capital structure. If it needs more capital, a number of different securities will be selected to
raise funds in the capital structure.
(ii) Factor of Industry:
A public utility company which has support from state and central government can raise
funds through preference share or debenture. A capital intensive company engaged in
manufacture may have high equity and less debt capital. A trading company having less
assets structure has to depend mainly on equity or preference capital.
(iii) Investors:
Investors are cautious over all the investments. Capital market is moving from equity to debt
and from debt to deep discount bonds. The finance manager must be careful in selecting the
securities for capital structure.
(iv) Cost of Flotation:
It refers to the expenses of a firm incurred during the process of public issue. Cost of flotation
of debt is comparatively less when compared to the cost of flotation of equity. One should try
to reduce this cost by a proper mix of debt and equity in the capital structure.
(v) Legal Requirements:
The legal and statutory requirements of the government, SEBI guidelines on investor
protection, equity ratio, promoter’s contributions etc., will have direct bearing on capital
structure and also monetary and fiscal policies of the government.
(vi) Period of Finance:
Short term funds, required to meet working capital requirements can be raised through
commercial banks. Medium term finance, required to meet expansion and diversification
purpose, can be raised through issue of preference or debenture capital- Long term or
permanent funds required to meet capital expenditure can be raised by issuing equity shares.
(vii) Lever of Interest Rate:
The rate of interest will have a direct impact on borrowed funds. If the expectation of the
banker or financial institutions is to get a high rate of interests then the firm can postpone the
mobilization of funds or make use of retained earnings. Hence it affects the capital structures.
(viii) Lever of Business Activity:
When the level of activity of a firm is rising, the additional funds required for expansion and
diversification can be raised through issue of debentures, preference shares or borrowing
terms loans.
(ix) Availability of Funds:
Free flow of money in the economy encourages a corporate to raise funds through securities
without much difficulty. The finance manager has to study the flow and availability of funds
before he decides about the capital structure.
(x) Taxation Policy:
High corporate taxes. Taxes on dividend and capital gains directly influenced the decision of
capital structure. High taxes discourage the issue of equity and encourage issuing more debt
instruments.
(xi) Level of Stock Prices:
If the general price level of stocks or raw material is constant over a period of time,
management prefers to invest such funds through long term or medium term financing. If the
prices are fluctuating widely Short term sources are the best alternative for investments.
10 .Financial Structure
Financial structure of a company is concerned with both long term and short term sources of
funds. Hence financial structure is the mix of all sources of funds whether long term such as
debt and equity or short term such as bank overdraft, short term loans etc.
11. Capital Gearing
Capital gearing has great importance in maintaining a strong financial position and organised
capital structure of a company. Capital gearing is defined as a ratio between equity share
capital and fixed cost capital bearing securities i.e., long-term debts, debentures and
preference share capital.
The formula is as follows:
Capital Gearing Ratio = (Equity Share Capital + Reserves and Surplus)/(Preference Share
Capital + Interest bearing Finance)
Definitions:
According to J. Batty, “The relation of ordinary share to preference share capital and loan
capital is described as the Capital gearing.”
According to Brown and Howard, “The term Capital gearing is used to describe the ratio
between the ordinary share capital and interest bearing securities of a company.”
Types of Capital Gearing:
1. High Gearing:
When the ratio of fixed interest bearing securities, debentures, preference share capital, long-
term debts etc., is more than equity share capital in the total capital of the company, it is
known as high gearing. For example, the total capital of the company is Rs.1 crore out of this
company collected Rs.25 lakh through issue of equity shares, Rs.20 lakh through issue of
10% preference shares and Rs.55 lakh through 8% debentures.
Thus capital gearing ratio will be:
25,00,000/(20,00,000 + 55,00,000) = 1:3 (High Gearing)
2. Low Gearing:
Low gearing is just opposite to the high gearing in the case of low gearing the ratio of
ordinary share capital is comparatively more than the fixed interest bearing securities,
debentures, preference share capital, long-term debts etc.
For example, the total capital of the company is Rs.1 crore out of this company collected
Rs.60 lakh through issue of equity shares, Rs.20 lakh through issue of 10% preference shares
and Rs.20 lakh through 8% debentures.
Thus capital gearing ratio will be:
60,00,000/(20,00,000 + 20,00,000) = 3:2 (Low Gearing)
Importance of Capital Gearing:
An optimum capital structure can be framed with the help of capital gearing. Usually in the
beginning, a company should follow the policy of low capital gearing, and as the business
and profits grow in future the policy of high capital gearing should be adopted. In fact a
balanced and overall capital gearing is very helpful in successful operation of a business
concern.
Effect of Capital Gearing during Trade Cycles:
1. Effect during Inflation or Boom Period:
During inflationary conditions a company can adopt high gearing and can increase the rate of
dividend for equity shareholders. In this period fixed interest bearing capital is used more and
more as the profits increased considerably.
In fact during the boom period the rate of interest or dividend payable on fixed cost securities
is much lower than the rate of profitability. Therefore a company can manage to pay
dividends to its equity shareholders at higher rates.
2. Effect during Deflation or Depression Period:
During the deflation period a company should adopt the policy of low gearing and should
issue variable cost bearing capital i.e., equity share capital more and more. In this period the
profits of the company fall and the rate of interest increases, hence a company will not be
able to pay fixed interest cost out of the profit available. So a company should not issue the
fixed cost capital but should prefer to maintain low gearing by issuing more and more equity
share capital.
At the end it may be said without any doubt that all the policies regarding capital structure
and financial management or administration of capital depends only on the balanced capital
gearing.
Illustration:
The capital structure of two companies X and Y is as under:
12. Capital Structure Theories
What is the relationship between capital structure, cost of capital and Company’s value?
There are different theories to answer this question. One school of thought firmly believes
that there is a relationship between value of the company and its overall cost of capital.
However according to another school of thought there is no relationship between the value of
company and its overall cost of capital. Remember, overall cost of capital is the outcome of
capital structure.
The following approaches are generally followed for examining the relationship between
the value of company and its capital structure:
1. Net Income approach (N.I.)
2. Net Operating Income approach (N.O.I.)
3. Modiglliani-Miller approach (M.M.)
4. Traditional approach (T)
Before we take each approach separately for discussion, let us mention the basic assumptions
regarding capital structure theories.
These assumptions are:
(i) There are only two sources of finances, viz., perpetual riskless debt and equity shares.
(ii) Corporate taxes are not in vogue.
(iii) Entire earnings are distributed as dividends i.e., dividend payout ratio is 100 percent.
(iv) In view of (iii) above, there are no retained earnings.
(v) The operating profit of the company is given and is not expected to grow.
(vi) All investors have the same subjective probability distribution of the expected future
earnings before interest and taxes for a given company.
(vii) Total assets of a company are given and these are not expected to change over a period
of time.
(viii) The company has a perpetual life.
(ix) Business risk is constant over time and it is independent of its capital structure and
financial risk.
Before going into further discussion, the following formula should be taken into
account:

13. Optimal/Optimum Capital Structure

In a financing decision, a financial manager’s job is to come out with an optimum capital
structure. Optimum capital structure is that capital structure at that level of debt – equity
proportion where the market value per share is maximum and the cost of capital is minimum.
The same to quote, Ezra, optimum leverage is that mix of debt and equity which will
maximise the market value of the company and minimise the company’s overall cost of
capital.
The study of capital structure involves a discussion of the nature of the industry and specific
circumstances of the business enterprise in question besides the general theory of finance. It
is difficult to define ideal capital structure.
A company’s capital structure is a function of the nature of its business and how risky the
particular business is and therefore, a matter of business judgment.
As observed by Van Home, “In the optimum capital structure, the marginal real cost of each
available method of financing is the same”. As Guthmann and Dougall rightly remark, from a
strictly financial point of view, the optimum capital structure is achieved by balancing the
financing so as to achieve the lowest average cost of long-term funds. This in turn produces
that maximum market value for the total securities issued against a given amount of corporate
income.
The optimum capital structure keeps a balance between share capital and debt capital. The
primary reason for the employment of debt by an enterprise can be stated as that up to a
certain point, debt is from the point of view of the ownership, a less expensive source of
funds than equity capital. Hence, optimum capital structure keeps a balance between debt
capital and equity capital.
14. Difference between Capital Structure and Capitalization
The important differences between Capital Structure & Capitalization are as under:

15. Differences between Capital Structure and Financial Structure

The important differences between Capital structure & financial structure are as
under:

Leverage Analysis

1. Meaning of Leverage
Leverage is used to describe the firm’s ability to use fixed cost assets or funds to magnify the
return to its owners. James van Home has defined leverage, as “the employment of an asset or
funds for which the firm pays a fixed cost or fixed return.” In other words, Leverage is the
employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of
interest obligation irrespective of the level of activities or the level of operating profit.
When a firm uses fixed assets, it Results in fixed operating costs. Similarly when a firm uses
those sources of finance in its capital structure on which it is required to pay fixed cost or
fixed rate of interest, it results in fixed financial costs. Higher is the degree of leverage higher
is the risk and higher is the expected return and vice versa.
The leverage can be favourable or unfavourable as the fixed cost or return has to be paid
irrespective of the volume of sales, the amount of such cost or return has a significant effect
on the profits available for equity shareholders.
2. Concept of Leverage
The term Leverage in general refers to a relationship between two interrelated variables. In
financial analysis it represents the influence of one financial variable over some other related
financial variable. These financial variables may be costs, output, sales revenue, earnings
before interest and tax, earnings before tax, earning per share, etc.
There are three commonly used measures of leverages in financial analysis. These are:
(i) Operating leverage,
(ii) Financial leverage, and
(iii) Combined leverage.
(i) Operating Leverage:
Operating Leverage is defined as “the firm’s ability to use fixed operating costs to magnify
effects of changes in sales on its earnings before interest and taxes”. In other words operating
leverage is the tendency of the operating profit to vary disproportionately with sales. It is said
to exist when a firm has to pay fixed cost regardless of volume of output or sales.
The operating leverage shows the relationship between the changes in sales and the changes
in fixed operating income. Thus, the operating leverage has an impact mainly on fixed costs
and also on variable costs and contribution. Of course, there will be no operating leverage if
there are no fixed operating costs.
The operating leverage can be calculated by adopting the following formula:

(ii) Financial Leverage:

The financial leverage is defined as the ability of a firm to use fixed financial charges to
magnify the effects of changes in operating profits, on the firm’s earning per share. In other
words, the financial leverage is the tendency of a residual net income to vary
disproportionately with operating profit. It indicates the change that takes place in the taxable
income as a result of change in the operating income.
The financial leverage can be computed by adopting the following formula:
(iii) Combined Leverage:
The operating leverage explains the operating risk and financial leverage explains the
financial risk of the firm. However, a firm has to look into overall risk or total risk of the firm
i.e., operating risk as well as financial risk. Hence, if we combine the operating risk and
financial risk, the result is combined leverage. Combined leverage thus expresses the
relationship between revenue on account of sales and the taxable income.
The combined leverage can be computed by adopting following formula:

3. Importance of Leverage
With the understanding of leverage, a finance manager can increase earnings per share and
dividend per share to equity shareholders as well as market value of the firm. When the rate
of return on investment is more than the cost of debt capital, it gives more rate of return on
equity capital. This in turn maximises shareholders’ wealth, which is the basic objective of
financial management. The leverage can help increase both the EPS and EBT.
The importance of leverage can be judged from the following points:
1. Leverage is an important technique in deciding the optimum capital structure of a firm.
With the help of this technique, it is easy to determine the ratio of various securities
comprising the capital structure of a firm at which the average cost of capital is minimum. If
financial leverage is present in a firm, it is possible to increase EPS by increasing the EBIT in
a firm.
2. Leverage is also very helpful in taking a capital budgeting decision. If contribution in a
firm is not able to meet the fixed operating costs, then business will suffer loss. In other
words, the degree of operating leverage must be greater than 1 to make the project
operationally profitable.
3. Leverage is most important in assessing the risk involved in a firm. Operating leverage
measures the business risk of a firm. Financial leverage measures the financial risk in a firm.
The combined leverage measures the total risk involved in a firm.
In leverage analysis, it is assumed that cost of capital always remains constant. But, after a
certain limit, the cost of financing generally starts increasing.
The use of more debt capital increases the risk level in a firm which results in reduction in the
value of shares. Thus, in leverage analysis, explicit cost of debt capital is considered, while its
implicit costs are ignored. Leverage principle assumes that the required additional debt
capital should.be raised till the expected rate of return on investment is higher than cost of
debt capital.
4. Types of Leverages
The leverage is of two types-
(i) Financial Leverage and,
(ii) Operating Leverage.
The leverage related to the activities (employment of fixed assets) is called operating
leverage. The leverage related to financing activities (employment of fixed cost bearing
sources of finance) is known as financial leverage.
Here, it is noteworthy that earnings before interest and tax (EBIT) are an important item in
the determination of operating and financial leverages. Earnings before interest and tax are
also called operating profit.
5. Pattern of Leverage
From the shareholders’ point of view, the pattern of leverage depends upon the fact as to
whether shareholders are benefitted or otherwise by the use of leverage.
If earnings after deducting variable costs (known as contribution) are more than fixed costs or
if earnings before interest and tax (EBIT) are higher than fixed return charges (i.e., fixed
interest and fixed dividend on preference shares), then it will be considered a case of
favourable leverage.
In other words, if the increases in operating profit increase the taxable profit, earning per
share, dividend per share and expected value of shares, then it will be termed as favourable or
positive leverage.
As contrary to this, the leverage may be considered unfavourable or negative when the
change in operating profit brings a decrease in taxable profit, earning per share, dividend per
share and expected market value of shares.
Thus, we can say that leverage is such a tool which operates on both sides. While on the one
hand, it increases the risk, it also provides opportunity, on the other hand raising the return on
capital employed. Till sales revenue’s level is high, high leverage succeeds in yielding more
than proportionate profit on owners’ capital.
But as soon as sales revenue falls, it also reduces the profit on owners’ capital in more than
proportionate rate. Thus, favourable leverage provides gains to shareholders and
unfavourable leverage results into losses to shareholders. Thus, it can be said that for trading
on high leverage, a high level of skill and prudence is desired.
6. Indifference Point
The indifference point refers to that level of EBIT at which EPS are the same regardless of
leverage in alternative financial plans. At this level, all financial plans are equally desirable
and the management is indifferent between alternative financial plans as far as the EPS is
concerned.
In other words, it is that level of EBIT at which it is immaterial for the financial manager as
to which capital structure or capital mix he adopts for the company. At this point, the use of
debt capital or a change in this proportion in the total capital will not affect the return to
equity shareholders or earning per share.
It is also called the debt-equity indifference point and can be determined
mathematically in the following manner:

Relevance of Calculation of Indifference Point:

The determination of indifference points helps in ascertaining the level of operating profit
(EBIT) beyond which the debt alternative is beneficial because of its favorable effect on
earnings per share.
In other words, it is profitable to raise debt for strengthening EPS, if there is likelihood that
future operating profits are going to be higher than the level of EBIT as determined. On the
other hand, it is advisable to issue equity shares for raising more funds if it is expected that
EBIT is going to be lower than that determined.
7. EBIT-EPS Analysis
The EBIT-EPS analysis is carried out to assess the impact of different financial proposals on
the value (EPS) of the company. Since the basic aim of financial management is to maximise
the wealth of shareholders, the EBIT-EPS analysis is crucial in maximising the wealth of the
company.
The financial proposal having the highest EPS is considered for the execution. The different
financial proposals may be the use of, only equity, combination of equity and debt,
combination of equity and preferential capital, or any combination of equity, debt and
preferential capital. EBIT-EPS analysis shows the impact of financial leverage on the EPS of
the company under different financial proposals.
The example given below explains the concept of EBIT-EPS analysis:
Example:
Tulip Limited is planning to set up an industrial plant costing Rs. 40,00,000. It is expected the
plant will yield an EBIT of Rs. 8,00,000 per annum.
The company has following financial proposals to meet the cost of the plant:
(i) To finance the project by issuing 4,00,000 equity shares of Rs. 10 each,
(ii) To finance the project by issuing 3,00,000 equity shares of Rs. 10 each and 1,00,000 10%
preferential shares of Rs. 10 each,
(iii) To finance the project by issuing 3,00,000 equity shares of Rs. 10 each and raising Rs.
10,00,000 by way of debt at 10%, or
(iv) To finance the project by issuing 2,00,000 equity shares of Rs. 10 each, 1,00,000 10%
preferential shares of Rs. 10 each and raising Rs. 10,00,000 by way of debt at 10%.
If the company is in the 40% tax bracket, which financial proposal is best?
Solution:
Computation of EPS under different financial proposals:

8. Financial Break Even Level

It is that level of EBIT at which EPS is zero and the firm is just able to meet all fixed
financial payments like interest on debt and preference dividend.
It can be found out by solving the following equation:

9. Limitations of Leverage
Leverage as a tool of financial management, suffers from the following limitations:
(a) Implicit Cost of Debt Ignored:
The leverage analysis relies on the explicit cost of debt. It suggests that the use of additional
debt capital as long as explicit cost of debt exceeds the rate of return on capital employed.
However, the increased use of debt capital tends to make the firm financially risky that is
reflected by reduction in price of shares in the market.
The intending investor in equity capital expects a higher rate of return as a compensation for
increase in risk. This additional risk premium is the implicit cost of debt that is completely
ignored.
(b) Increase in Cost of Debt:
With increase in use of debt, the debt equity ratio tends to increase. As a result, the
prospective providers of debt funds hesitate to provide additional debt, except at a higher rate
of interest. But a basic assumption of leverage analysis is that the cost of debt capital remains
unchanged irrespective of amount of borrowings.
(c) Debt with Captive Market:The biggest limitation of the leverage analysis is that they
look at the total amount of borrowing, not the firm’s ability to actually service its debt. Some
firms, with captive markets, may carry a significant amount of debt, but they generate enough
cash to easily handle interest payments. Such firms are labeled as being risky though they
may not be because of the captive market they enjoy.
Types of Leverages – Operating Leverage, Financial Leverage and Combined Leverage
The essential element in analysis of the capital structure of the firm is the effect leverage will
have on it. Leverage is defined basically as the firm’s utilization of an asset or liability which
requires a fixed payment. It is said that leverage is a double-edged sword.
When earnings before interest and taxes exceed the fixed obligations, favorable leverage
occurs; when fixed obligations exceed earnings before interest and taxes, unfavorable
leverage occurs.
Type # 1. Operating Leverage:
Operating leverage refers to the degree to which operating fixed costs are used in the
operations of the firm. The impact of fixed costs on the profit structure of the firm can be
judged with the analytical tool of break-even analysis.
The importance of operating leverage as it relates to profitability can be shown in Figure 2,
which considers two firms with different levels of operating leverage. Firm A has fixed costs
of Rs.30,000, variable costs per unit of Rs.1.50 and a per unit sales price of Rs.2.50.
At this level of operating leverage, the break-even point is 30,000 units of production. Firm B
has the same selling price but a higher level of operating leverage in the form of fixed costs
of Rs.60,000.
The per unit variable costs have been reduced to Re. 1, due in part to the fact that the firm has
more automated equipment than firm A. However, at the same level of output where firm A
was breaking even, firm B is still losing Rs.15,000. The break-even point for firm B is 40,000
units.
In utilizing more operating leverage, the firm may magnify its profits, but it may also
magnify its losses. Table 1 shows the level of profitability at different levels of production for
firms A and B. At 10,000 units sold, firm A is losing Rs.20,000, while firm B is losing
Rs.45,000.
At an output level of 110,000 units, firm A has a profit of Rs.80,000, while firm B has a profit
of Rs.105,000. Increased leverage will magnify profits at high levels of output but will
magnify losses at low levels of production. Once a higher level of fixed costs is assumed, it is
difficult to eliminate these costs if sales do not reach the expected level.

Degree of Operating Leverage:

In addition to examining the impact of operating leverage over a range of outputs, we can
also measure the operating leverage effect at a specific level of output. This is called the
degree of operating leverage. It measures the impact that operating leverage has on earnings
before interest and taxes (EBIT) given a change in output.
This is shown in Equation 1:

Instead of calculating the percentage changes in output and EBIT, we can look at per unit data
as given in Table 1 and calculate the degree of operating leverage at a level of output.
This operation is shown in Equation 2:

The two equations above show the effect of operating leverage on earnings before interest
and taxes. To illustrate the calculating procedure, we can examine the data for firm A and B in
Table 1 and calculate the degree of operating leverage at 50,000 units.
This is shown for Firm A as:

At a level of output of 50,000 units, firm A has a degree of operating leverage of 2.5, and firm
B has a degree of operating leverage of 5.0. As the level of output changes, so will the degree
of operating leverage. The further from the break-even point, the lower will be the degree of
operating leverage.
With a degree of operating leverage of 25, if firm A expected to increase its level of output by
10 per cent, Equation 1 indicates that the expected increase in EBIT would be 25 per cent.
For firm B, a 10 per cent increase in the level of output would increase EBIT level by 50 per
cent. Thus firm B has the higher degree of operating leverage.
The impact of the operating leverage on EBIT will be shown to be even stronger when
financial leverage is introduced and the combined leverage effect can be examined.
Type # 2. Financial Leverage:
Financial leverage is defined as the extent to which the firm utilizes limited participating
funds obtained at a fixed cost in the hopes of increasing returns to common shareholders.
Favorable leverage occurs when the firm invests these funds at a return that is greater than the
associated fixed cost. Unfavorable leverage occurs when the return on these invested funds is
less than the fixed cost.
Impact of Financial Leverage on Earnings per Share:
Any firm that is considering the use of debt or preferred stock in its capital structure must
weigh the impact that the increased leverage will have on earnings per share. Management’s
object in seeking these funds is to increase the earnings per share. The example below
illustrates how debt and stock financing affect this aspect of a company’s financial position.
A company attempting to raise Rs.50 lakhs determines that the funds can be raised through a
debt, a preferred stock, or a common stock issue. If the funds are raised through the debt
instrument, the firm would pay an annual rate of interest of 7 per cent. If preferred stock is
used, the firm would pay an 8 percent dividend. If the funds are obtained through the equity
market, 50,000 new shares would be issued at Rs.100 market price.
The firm has outstanding 50,000 shares of common stock. Table 2 illustrates the impact of
these three financing sources on earnings per share by examining them over different
earnings levels.
Given future uncertainty in the economy, the firm estimates that earnings before interest and
taxes (EBIT) could vary anywhere from Rs.400,000 to Rs.2 million.
In the debt or bond financing alternative, the 7 per cent interest charges of Rs.350,000 and the
48 per cent tax charge must be deducted before determining the earnings per share (EPS).
The EPS will range from 52 paise to Rs.17.16 as the EBIT figure increases.
In the example, it is assumed that this is the only debt outstanding and the firm has
outstanding 50,000 shares of stock. With the preferred stock issue, the impact on earnings per
share is more volatile because the preferred dividends are paid on an after-tax basis. Thus the
earnings per share will vary from a deficit of Rs.3.84 to Rs.12.80.
With the common stock offering, the number of shares would increase to 100,000, and, since
there is no interest to deduct, the earnings per share would range from Rs.2.08 to Rs.10.40 as
the earnings before interest and taxes increase.
The table shows that under certain EBIT levels, the earnings per share under the debt
financing alternative is larger than under the stock financing alternative, and at high EBIT
levels, earnings per share are higher for preferred stock financing than for common stock
financing.
This phenomenon can be illustrated in Figure 3 which graphs the relationship between
earnings before interest and taxes, and earnings per share for the common stock, preferred
stock, and debt financing alternatives.
Note that for all levels of EBIT below Rs.700,000, the common stock financing alternative
provides the higher EPS figure, and for all EBIT levels above, this level, the debt alternative
provides the highest EPS. The crossover point is called the indifference point. This shows the
point at which comparative methods of financing will yield the same results in earnings per
share.
To calculate the indifference point between two financing alternatives we equate the two
sources of financing, as in Equation 3 and solve for EBIT:

To determine the indifference point, we must know the level of earnings before interest and
taxes (EBIT) at which two financing plans will provide the same earnings per share. This
level of EBIT will vary with different numbers of common shares outstanding, different
amounts of interest, or different amounts of preferred dividends. This is why the EBIT level
must be adjusted as shown in the numerator of Equation 3.
The EBIT level is adjusted by subtracting the interest payments and the before-tax preferred
stock dividends and then adjusting this figure for the tax effect. To put this amount on a per
share basis, we divide by the number of common shares for each financing plan.
To illustrate this concept, we will examine the common stock and the debt alternatives
outlined in Table 2. The debt alternative has an associated interest charge of Rs.350,000 with
50,000 shares of stock outstanding, and the stock alternative had no interest charges
associated with it, but the firm would have to issue an additional 50,000 shares.
To solve for the indifference point, we set the two equations equal to each other and solve for
EBIT, as shown in Equation 4.

As Figure 3 shows, at an EBIT level below Rs.700,000, the common stock plan provides the
higher earnings per share, and at an EBIT level above Rs.700,000 the bond or debt financing
plan provides the higher earnings per share. Below the indifference point, the burden of the
interest payments is too great in terms of the effect on EPS; thus the common stock financing
plan will have higher earnings per share because there is no interest burden.
At high levels of EBIT the fixed interest charges are more than compensated for, however,
because the increased number of shares issued on the stock plan is so great that the earnings
available to the common shareholders are spread too thin. The result is a lower level of
earnings per share relative to the debt alternative.
For the preferred stock versus the common stock alternative, the indifference point is at the
Rs.1.6 million EBIT level. The reason such a level of EBIT is necessary before the preferred
stock financing alternative has a higher level of earnings per share is because preferred stock
dividends are paid out of after-tax income. The effect is to reduce the earnings per share as
compared to the common stock financing plan.
The degree of financial leverage at a particular EBIT level is measured by the percentage
change in earnings per share relative to the percentage change in EBIT.

For the debt-financing alternative at an EBIT level of Rs.1 million, the degree of
financial leverage would be:
With the debt alternative, a 100 per cent increase in EBIT would lead to a 154 per cent
increase in earnings per share. The higher degree of financial leverage associated with
preferred stock is due to the higher financial costs on a before tax basis which act as the
fulcrum in the leverage analysis.
The double-edged sword concept of financial leverage is dearly demonstrated in this
illustration. In periods of high sales and a high EBIT level, the use of debt will magnify the
gain to be obtained in earnings per share, compared to common stock or preferred stock
financing. The increased earnings per share are the result of the tax effect on the debt interest
payments. Because interest is an expense which is deductible before tax, it acts as a tax shield
for the corporation.
However, in periods of low sales, the interest charges become a fixed burden for the
corporation which severely hurt its EPS record, as shown in Figure 3.
The importance of an accurate sales forecast cannot be stressed enough. If the firm expects a
high level of sales and it finances this sales growth through a Rs50 lakhs debt offering, if
sales do not reach the level of expectation the firm will face a debt service cost which will
impair its EPS record. However, if the firm is correct about the high sales forecast, its profits
will be magnified, as shown by the debt line in Figure 3.
Note that the debt line is growing much faster than the stock financing line, indicating the
magnification of earnings on both the high and low sides.
This type of analysis is not limited to debt or common stock financing. We can also utilize it
in analyzing a combination of debt and equity financing alternatives in order to determine the
effect of the various combinations on the earnings per share of the firm.
Impact of Financial Leverage on the Return to Equity Holders:
Increasing the amount of leverage can magnify the earnings per share of the firm, and thus
the shareholder’s wealth, when sales are at relatively high levels. The effect on the
shareholder’s wealth can be more vividly illustrated by examining the impact of leverage on
the return to common equity. In the example below we will ignore the effect of preferred
stock financing, to simplify the discussion.
One of the ways to examine the relationship between leverage and the return to common
equity, is through the use of the earnings in developing the concept of the return on total
assets and the debt to total asset ratio, we defined the return on total assets as net income after
taxes as related to total assets.
The effect on the equity holders can be illustrated in Equation 5:
Assuming that the return on total assets remains constant, the return on common equity can
be increased by increasing the debt to total asset ratio, which is the measure of leverage. This
will decrease the value of the denominator, which, when divided into the numerator, will
increase the return on net worth.
This relationship is further illustrated in Table 3 which considers Rs.10 million asset level and
various returns on total assets which reflect different levels of economic activity resulting in
poor to excellent sales.
As the sales level increases, the return on total assets also increases, assuming that the
relationship of costs to sales and total assets to sales remains the same. In addition, under
each return to total asset column, various leverage levels are examined in order to show the
impact on the return on net worth.
For example, if a 6 per cent return on total assets before interest and taxes is expected, the
return with no (0 per cent) leverage is 3.1 per cent; with 25 per cent leverage, 2.9 per cent;
and with 50 per cent leverage, 2.6 per cent. This decrease is due to the earnings not being
high enough to absorb the interest cost, resulting in a negative impact on net income available
for shareholders.
This is verified in the table, which shows that the return to shareholders decreases as leverage
increases at an EBIT level of Rs.600,000. Above the Rs.600,000 level, the return to
shareholders increases as the leverage factor increases.
 Note that the double-
edged sword is at work again. At low and high levels of profitability; increasing the amount
of leverage will magnify the loss potential and magnify the gain potential.
Thus, if the firm forecasts a high sales level and increases leverage to 50 per cent, as
measured by the debt to total asset level, it will have the highest expected gain. However, if
management is wrong in its forecast, the losses will also be magnified as compared to a lower
level of leverage.
Type # 3. Combined Leverage:
Consideration of the combined effects of operating and financial leverage magnifies the
effects of leverage on earnings per share. The two leverage factors together increase the
dispersion and rid; of forecasting earnings per share.
To measure this combined effect, we can multiply the degree of operating leverage by the
degree of financial leverage. This will shows the effect that a change in output will have on
earnings per share.
In essence, earnings before interest and taxes is really X (italic P -V)-F, where X is the units
of output, P is the price per unit, V is the variable cost per unit, and F is the fixed cost. Thus-

Note that the fixed financial costs, Y, is increase the degree of combined leverage over
operating leverage alone.

Types of Leverages – With Problems, Interpretation and Computation

Leverages can be divided into three, i.e.:
1. Operating leverage,
2. Financial leverage, and
3. Combined leverage.
Type # 1. Operating Leverage:
Joy O. M. in his book introduction to financial management has defined operating leverage as
“the leverage associated with investment (asset acquisition) activities is referred to as
operating leverage.” In simple terms, operating leverage is the tendency of the operating
profit to vary with sales. Operating leverage results from the existence of fixed operating
expenses, in the firm’s income stream.
The operating expenses can be divided into three:
(a) Fixed Costs:
These expenses do not vary with sales volume, that is, these expenses are a function of time,
mostly contractual and must be paid regardless of the amount of sales. For example- salary to
staff, rent for the building, etc.
(b) Variable Costs:
These expenses vary directly with the sales volume. For example- materials, labour expenses,
etc.
(c) Semi Variable Costs:
Are those which are partly fixed and partly variable. For example- depreciation, telephone
charges, etc. It is to be remembered that operating leverage occurs only when fixed costs are
to be met, regardless of sales volume. Operating leverage may also be defined as the “firm’s
ability to use fixed operating costs, to magnify the effects of changes in sales, on its earnings
before interest and taxes.” The earnings before interests and taxes are generally called as
operating profits. Let us explain operating leverage with few examples.
Problem – 1:
A firm sells its products at Rs. 1,000 per unit, has variable operating expenses of Rs. 500 per
unit and fixed operating costs of Rs. 5,00,000 per year. Analyse the various levels of EBI that
would result from the sale of 1,000 units (b) 2,000 units and (c) 3,000 units.
Solution:

Interpretation:
(a) Case 1:
A 50 percent increase in sales (from 20,000 to 30,000 units) results in a 100 percent increase
in EBIT (that is, from Rs. 5,00,000 to Rs. 10,00,000), that is –

(b) Case 2:
Similarly in case 2, a 50 percent decrease in sales from (2,000 units to 1,000 units), results in
a 100 percent decrease in EBIT (from 5,00,000 to zero).
The example clearly shows that when a firm has fixed operating costs, an increase in sales
volume, results in a more than proportionate increase in EBIT. (Case 1). This is known as
favourable operating leverage. Similarly from Case 2 it is clear that a decrease in the level of
sales, has an exactly opposite effect. This is known as unfavourable operating leverage. Thus
leverage works in both directions.
Computation:
Operating leverage in a firm is affected due to three factors:
(1) The amount of fixed costs,
(2) The contribution margin (that is, sales – variable expenses), and
(3) The volume of sales.
Operating leverage is calculated using the formula –

Degree of Operating Leverage (DOL):

The degree of operating leverage, measures in quantitative terms the extent or degree of
operating leverage. It may be defined as “percentage change in the operating profits, resulting
from a percentage change in the sales.”
It can be calculated using the following equation:

Since DOL exceeds one, operating leverage exists. It means that for every one percent change
in sales, there will be two percent change in EBIT in the same direction in which the sales
change. As already pointed out operating leverage exists only when there are fixed operating
costs. If there are no fixed operating costs, there will be no operating leverage.
It can be explained with the help of the following example:
Problem – 2:
DOL is one that means there is no operating leverage. It exists only when DOL exceeds one.
Type # 2. Financial Leverage (FL):
Financial leverage is the second type of leverage. It is related to the financing activities of the
firm. Financial leverage results from the presence of fixed financial charges in the firm’s
income stream. These fixed charges do not vary with the earnings before interest and taxes
(EBIT), or operating profits. They have to be paid regardless of the amount of EBIT and after
meeting the fixed costs, the remaining operating profits belong to the ordinary shareholders.
Thus financial leverage is concerned, with the effect of changes in EBIT and the earnings
available to equity shareholders. Financial leverage may be defined as, “the ability of a firm
to use fixed financial charges to magnify the effects of changes in EBIT, on the firm’s
earnings per share.” in other words financial leverage or trading on equity involves the use of
funds obtained at a fixed cost, to magnify the returns to the equity shareholders.
Financial leverage can be explained with the help of the following example:
Problem – 3:
H Ltd has an EBIT amounting to Rs. 1,00,000. The firm has five percent bonds aggregating
Rs. 4,00,000 and 10% shares amounting Rs. 2,00,000. Calculate the EPS? Assuming the
EBIT being (1) 60,000 and (2) Rs. 1,40,000, how would the EPS be affected. The firm is in
the 50 percent tax bracket. The number of outstanding equity shares is 1,000.
Solution:
Interpretation:
1. In case one, a 40 percent increase in EBIT (from Rs. 1,00,000 to Rs. 1,40,000), results in
100 increase in EPS (from Rs. 20 to Rs. 40)

2. Similarly in case two, a 40 percent decrease in EBIT (from Rs. 1,00,000 to Rs. 60,000),
leads to a 100 percent decrease in EPS (from Rs. 20 to 0).
Degree of Financial Leverage (DFL):
DFL measures in quantitative terms, the extent or degree of financial leverage. It can be
calculated using the equation –
This means that one percent change in EBIT, will cause 2.5 percent change in EPS in the
same direction, (that is, either increase or decrease) in which the EBIT changes. As in the
case of operating leverage, there will be no financial leverage, if there is no fixed cost
financing.
Computation:
Financial leverage is affected due to fixed cost charges. It is calculated using the equation-
Financial Leverage = EBIT/PBT = Earnings Before Interest and Tax/ Profit Before Tax
Significance of Financial Leverage:
High fixed financial costs increase the firm’s financial risk. The financial risk refers, to the
risk of the firm not being able to cover its fixed financial costs. EBIT should be sufficient to
cover the fixed charges; otherwise it may force the company into liquidation.
Significance of Operating Leverage:
Higher the fixed operating costs, the higher the firm’s operating leverage and its operating
risk. High operating leverage is good when sales revenue is high and bad when it is falling.
Operating risk is the risk of the firm not being able to cover its fixed operating costs. The
larger the fixed operating costs, the larger should be the sales volume to cover all fixed
operating costs.
Type # 3. Combined Leverage or Composite Leverage:
Operating leverage has its effects on operating risk and is measured by the percentage change
in EBIT, due to percentage change in sales. The financial leverage has its effect on financial
risk and is measured by the percentage change in EPS due to percentage change in EBIT.
These leverages are ascertaining the firm’s ability to cover fixed charges, (that is, fixed
operating costs in the case of operating leverage and fixed financial costs in the case of
financial leverage). If we combine them, we get the total leverage and total risk.
Symbolically, CL = OL x FL

Significance of DCL:
DCL measures the percentage change in EPS, due to percentage change in sales. For
example- if the DOL of a firm is 6 and DFL of that firm, is 2.5, then DCL = 6 x 2.5 = 15.
That means, one percent change in sales, would bring about 15 percent changes in EPS. Like
other leverages, combined leverage also work in both directions – that is, it will be
favourable, if sales increases and unfavourable when sales decreases.
Let us explain these leverages with the help of few examples:
Problem – 4:
A firm sells its products for Rs. 50 per unit, has variable operating costs of Rs. 30 per unit and
fixed operating costs of Rs. 5,000 per year. Its current level of sales is 300 units. Calculate the
firm’s degree of operating leverage. What will happen to EBIT if sales change? Let us
suppose that the sales level (a) rises to 350 units, and (b) decreases to 250 units.
Solution:

Interpretation:
DOL is six means that for one percent change in sales, operating profit will increase by six
percent.

Types of Leverages – With Formulas and Applications

1. Operating Leverage:
The operating leverage is created by a firm through using fixed operating costs in the
production. Operating leverage comes into operation when changes in sales bring more than
proportionate change in operating profit (EBIT).
According to Solomon Ezra, “Operating leverage is the tendency of the operating profit to
vary disproportionately with sales.”
According to John Hampton, “Operating leverage exists when changes in revenue produce
greater changes in EBIT.”
Table 6.1 shows working of operating leverage in case of three firms having varying
operating cost structure. In next year, when sales revenue increase by 100%, the operating
profits of the three firms increase by varying percentages, i.e. by 700% in case of firm A,
200% in firm B and by 533% in firm C.
This happens because of different operating leverages of the firms. The ratio of contribution
to EBIT in a firm indicates its operating leverage. And the contribution depends of presence
of fixed costs in the operating cost structure of a firm.
Thus, operating leverage in a firm depends on the following factors:
(i) Fixed costs
(ii) EBIT.
Higher the degree of operating leverage in a firm, higher will be the increase in operating
profit for a given change in volume of sales.
In fact, there will be no operating leverage if there are no fixed operating costs. Operating
leverage creates ‘operating risk’ or ‘business risk’ in a firm. Business risk is the firm’s
inability to meet the fixed operating costs. Higher the fixed operating costs in relation to
operating profits, higher is the degree of operating leverage and higher will be the
business/operating risk for the firm.
The operating leverage is based on the theory of cost volume profit analysis. The presence of
fixed costs in total costs gives birth to operating leverage. However, it would be an error to
assume that the firm with largest absolute or relative amount of fixed assets automatically
leads to highest degree of operating leverage.
Significance of Operating Leverage:
The knowledge of operating leverage is very useful in deciding sales policy or capital
structure of a firm. With the help of operating leverage the manager would know in advance
the impact of potential change in sales on the operating profit. Firms may take decision to
make some changes in its sales policy or cost structure on the basis of prior knowledge of
operating leverage.
Usually, firms do not like to operate under the conditions of a high degree of operating
leverage. If a firm operates under a high degree of operating leverage, a small drop in sales
may cause operating loss.
Highly automated firms bear a heavy fixed cost and operate under condition of high degree of
operating leverage. A small change in sales in such firms may cause huge change in operating
revenue.
Applications of Operating Leverage:
The operating leverage can be used to meet the following purposes:
1. Selection of Investment Projects:
The advance knowledge of operating leverage helps in selection of investment projects. If
other conditions remain same, the investment project with lower degree of operating leverage
should be selected.
2. Selection of Capital Structure:
The capital structure of a firm shows the mix of debt and equity. If the operating leverage of a
firm is high, the firm should use low amount of debt in its capital so that in case of loss the
burden of fixed interest for the debt could be avoided.
3. Assessment of Operating or Business Risk:
The degree of operating leverage indicates the degree of operating or business risk involved
in a firm. This helps a firm in preparing its long-term business/profit policy.
4. Selection of Sales Policy:
The operating leverage helps in advance in determining the impact of change in volume of
sales on operating profit of a firm. Having the prior knowledge of such impact, a firm can
easily decide its sales policy.
2. Financial Leverage:
Financial leverage is created by use of fixed charge securities in the capitalisation of a firm.
Financial leverage is defined as the firm’s ability to use fixed financial expenses in such a
way that any increase in operating profit (EBIT) has magnifying impact on the net profit
(EPS).
According to Hampton, “Financial leverage exists whenever a firm has debt or other sources
of funds that carry fixed charges.”
In the words of Gitman, “The ability of a firm to use fixed financial charges to magnify the
effects of changes in EBIT on the firm’s earnings per share is financial leverage.”
The following example given in Table 6.2 will help in explaining the concept of financial
leverage. The three companies A, B and C have different capital mix in the total capitalisation
of Rs. 5 lakh. Each company earns operating profit Rs. 1,00,000.
Their EPS are different owning to different proportion of fixed charge securities in the
capitalisation. In the next year, operating profit (EBIT) increases by 100% in case of all the
three companies. The EPS increases by 100% in case of company A, while it increases by
140% and 125% respectively in case of companies B and C.
This happens due to different degrees of financial leverage in these companies caused by
varying proportion of fixed charge securities (debt and preferential shares) in their total
capital. Company A has no fixed charge securities in its capital, hence % change in EPS is
equal to % change in Operating profit.
Company B has Rs. 2,00,000 preferential share capital and its EPS increased by 140%.
Company C has Rs. 2,00,000 debt and its EPS increases by 125%. This shows that the
presence of fixed charge securities in capital structure of a firm has magnifying impact on its
EPS.
Financial leverage indicates the financial risk involved in the operation of a firm. Financial
risk is the risk of a firm’s inability to meet the fixed financial obligations. Higher the
proportion of debt in the capitalisation of a firm, the higher will be the degree of financial
leverage and the higher financial risk. There is more probability that a firm fails to discharge
its financial obligations.
The financial leverage is said to be favourable or positive, when the firm earns more on its
investment than what it pays to fixed charge securities in the form of preferential dividend or
interest. The surplus after payment of fixed financial charges belong to equity owners.
If the firm earns a return on investment less than the rate at which it pays interest to debt
holders, then it negative or unfavourable leverage. In such a situation, firm pays the interest
on debt from the profit belonging to the shareholders. In other words, there exists no financial
leverage.
If degree of financial leverage is less than 1, there exists no financial leverage. In case the
degree of financial leverage is equal to 1, the return on investment is equal to rate of interest
payable to debt holders. If degree of financial leverage is more than 1, there exists financial
leverage. In this case, return on investment is greater than rate of interest payable to debt
holders.
If financial leverage exists in firm, when degree of financial leverage is greater than 1, it is
called trading on equity. This implies that the firm’s rate return on investment is greater than
the rate of interest payable to debt holders. In this situation, an increase in operating profit of
the firm leads to more than proportionate increase in earnings per share.
Importance of Financial Leverage:
Financial leverage signifies the use of debt and preferential share capital for magnifying the
profit available to the equity shareholders. A business firm may increase the profit for equity
shareholders by increasing the EBIT through the raising of funds from fixed cost sources e.g.
debentures, loans and preferential share capital.
The degree of financial leverage helps us to understand how earning per share would change
with respect to change in the operating profit. Debt is relatively cheaper source of funds than
equity and preferential share capital. The use of debt reduces the overall or weighted average
cost of capital of a firm. The reduced overall cost of capital contributes to increased valuation
of the firm. This is the basic purpose of financial management.
The degree of financial leverage indicates the financial risk involved in a firm. The
knowledge of financial leverage helps in judiciously designing the capital structure of a firm
in such a way to reduce the overall cost. The understanding of financial leverage also helps in
the capital budgeting of a project.
Applications of Financial Leverage:
The degree of financial leverage in a firm depends on its capital structure. The understanding
of financial leverage helps the management of a firm to decide about any change in use fixed
cost securities in the total capital of the firm.
The financial leverage is said to be favourable or positive, when the firm earns more on its
investment than what it pays to fixed charge securities in the form of preferential dividend or
interest.
If the firm earns a return on investment less than the rate at which it pays interest to debt
holders, then it negative or unfavourable leverage. In such a situation, firm pays the interest
on debt from the profit belonging to the shareholders. In other words, there exists no financial
leverage.
If degree of financial leverage is less than 1, there exists no financial leverage. In case the
degree of financial leverage is equal to 1, the return on investment is equal to rate interest
payable to debt holders. If degree of financial leverage is more than 1, there exists financial
leverage. In this case, return on investment is greater than rate of interest payable to debt
holders.
If financial leverage exists in firm, when degree of financial leverage is greater than 1, it is
called trading on equity. This implies that the firm’s rate return on investment is greater than
the rate of interest payable to debt holders. In this situation, an increase in operating profit of
the firm leads to more than proportionate increase in earnings per share.
If rate of return on investment is equal to the cost of debt, then the firm should not use
leverage. In such a situation, more use of debt capital will increase the financial risk instead
of the EPS.

Types of Leverages – With Formulas and Interpretation

A. Operating Leverage:
Most of the business organization incur costs in the process of making profits, these costs are
of two types namely, fixed cost and variable costs. Fixed costs are expenses incurred in the
course of business that does not change with an increase or decrease in the production and
sales volume.
On the other hand variable cost are expenses that vary with organization’s production output
and sales volume. From the perspective of business fixed cost remains a concerns as the firm
must bear it whether sales and production takes place or not, on the other variable cost may
not be an issue of concern because a firms has to bear variable cost according to volume of
production and sales. Therefore, Operating leverage is a measure to establish relation
between a firm’s fixed cost and variable cost and its impact of profits.
If a firm has high fixed costs and if not able generate sufficient sales revenue then it will not
be in a position to absorb fixed costs, this means the firm has high operating leverage which
means high business risk. As the volume of sales increases, each new sale contributes reduce
the fixed costs and increase the profitability.
Meaning – Operating leverage is the ratio of fixed costs to variable costs.
Definition – Operating Leverage:
According to L. J. Gitman ‘Operating leverage is concerned with the relationship between the
firm’s sales revenue and its operating profits (EBIT)’.
Formula for Calculating Operating Leverage (OL):
Interpretation:
A firm with Lower fixed costs and higher/lower variable costs is said to have low operating
leverage (business risk) and a firm with High fixed costs and higher/lower variable costs is
said to have high operating leverage (business risk). Thus, firms with high operating leverage
are very sensitive to changes in sales and it affects their profitability.

B. Financial Leverage:
It determines the impact of using debt financing (debentures and bonds or long term loans) on
the earnings of shareholders. Financial leverage is primarily concerned with use of debt
capital, a company with a capital structure based largely on debt is required to pay interest to
the debt holders, regardless of how the company is performing.
Companies that uses more of debt capital are called highly leveraged and exposed to risk of
insolvency if it fails to make payments on debt capital it may also find difficult to borrow
funds from new lenders in the future. This risk of failure to pay interest and insolvency is
termed as “Financial Risk”.
However financial leverage is not always bad, there are tax advantages associated with debt
repayments. Since interest paid on debt capital is deductible from profit and loss account, this
result in lower tax liability which in turn increases the earning of the shareholders. Therefore
if a firm uses more of debt capital in order to increase the earnings of shareholders it is said to
be “trading on equity”. Therefore financial leverage is also termed as “trading on equity”.
Financial Leverage – Definition:
L. J. Gitman defines financial leverage as the firm’s ability to use fixed financial charges to
magnify the effects of changes in EBIT on the firm’s earnings per shares.
Financial Leverage – Meaning:
Financial leverage refers to the extent of fixed cost debt capital used by a firm in order to
maximize the earning of shareholder, financial leverage is also termed as “trading on equity”.
Formula for Calculating Financial Leverage (FL):
Interpretation:
A higher financial leverage signifies use of more fixed cost capital in comparison with equity
capital in the capital structure of the company. A lower financial leverage signifies use of less
fixed cost capital in comparison with equity capital in the capital structure of the company.
Thus, if a firm has sufficient earnings to meet its debt obligation then it is said to have
favorable financial leverage and if it does not have earnings to meet its debt obligation it is
said to have unfavorable financial leverage.