Leverage and Capital

Structure

Leverage
Leverage results from the use of fixed-cost
assets or funds to magnify returns to the
firms owners.
Generally, increases in leverage result in
increases in risk and return, whereas
decreases in leverage result in decreases
in risk and return.

Types of Leverage
1. Operating leverage is concerned with the
relationship between the firms sales revenue
and its earnings before interest and taxes
(EBIT)
2. Financial leverage is concerned with the
relationship between the firms EBIT and its
common stock earnings per share (EPS)
3. Total leverage is concerned with the
relationship between the firms sales revenue
and EPS.

Financial leverage and capital structure are

closely related concepts that can minimize
the cost of capital and maximize owners
wealth.
Capital structure is the mix of long-term debt
and equity.
Adding debt, with its fixed rate, to the capital
structure creates financial leverage.

Types of Capital

Degree of Operating Leverage

The degree of operating leverage (DOL)
measures the sensitivity of changes in
EBIT to changes in Sales.
A companys DOL can be calculated in
two different ways: (1) a point estimate;
(2) an interval estimate .
Only companies that use fixed costs
in the production process will experience
operating leverage.

(1) a point estimate

DOL at base Sales level Q :
Q X (P VC)
Q X (P VC) FC

(2) an interval estimate

DOL = Percentage change in EBIT

Percentage change in Sales

Financial Leverage
Financial leverage can therefore be
defined as the potential use of fixed
financial costs to magnify the effects of
changes in EBIT on the firms EPS.
The two fixed financial costs most
commonly found on the firms income
statement are (1) interest on debt and (2)
preferred stock dividends.

Degree of Financial Leverage

The DFL measures the sensitivity of
changes in EPS to changes in EBIT.
DFL can be calculated in two different
ways: (1) a point estimate; (2) an interval
estimate .
Only companies that use debt or other
forms of fixed cost financing (like preferred
stock) will experience financial leverage

(1) a point estimate

DFL at base level EBIT =
EBIT
EBIT I [PD x 1/(1-T)]

2) an interval estimate .
DFL =
Percentage change in EPS
Percentage change in EBIT

Total Leverage
Total leverage results from the combined
effect of using fixed costs, both operating
and financial, to magnify the effect of
changes in sales on the firms earnings
per share.
Total leverage can therefore be viewed as
the total impact of the fixed costs in the
firms operating and financial structure.

EPS
(1- t ) x (EBIT I) PD
n

Business risk and Financial risk

Business risk is the risk to the firm of being
unable to cover operating costs. Business
risk is also affected by revenue and cost
stability.
Financial risk is the risk of being unable to
meet its fixed interest and preferred stock
dividends.

Contoh:
Cables Inc., a computer cable manufacturer,
expects sales of 20,000 units at $5 per
unit in the coming year and must meet the
following obligations: variable operating
costs of $2 per unit, fixed operating costs
of $10,000, interest of $20,000, and
preferred stock dividends of $12,000. The
firm is in the 40% tax bracket and has
5,000 shares of common stock
outstanding.

DOL
(1) DOL at 20,000 units =
20,000 X ($ 5 - $2)
= 1,2
20,000 X ($ 5 - $ 2) - $ 10,000
(2) DOL = (+60% +50%) = 1,2

DFL
(1) DFL at $50,000 EBIT =
$50,000
$50,000 $20,000 [$ 12,000 x 1/(1- .4)]
=5
(2) DFL = (+300% +60%) = 5

Degree of Total Leverage

DTL = Percentage change in EPS
Percentage change in Sales
Degree of Total Leverage (DTL) =
(300% 50%) = 6

DTL at base sales level =

Q X (P VC)
Q X (P VC) FC I [PD x 1/(1-T)]

DTL at 20,000 units =

20,000 X ($5 $2)
20,000 X ($5 $2) $10,000 $20,000 [$12,000 x 1/(1-.4)]

$ 60,000/$10,000 = 6

The Relationship of Operating,

Financial and Total Leverage
DTL = DOL x DFL
1,2 x 5 = 6

Capital structure
According to finance theory, firms possess
a target capital structure that will minimize
its cost of capital.
Poor capital structure decisions can result
in a high cost of capital, thereby lowering
project NPVs and making them more
unacceptable.

 Effective decisions can lower the cost of

capital, resulting in higher NPVs and more
acceptable projects, thereby increasing
the value of the firm.
Theoretically, however, a firms optimal
capital structure will just balance the
benefits of debt financing against its costs

EPS-EBIT Approach
to Capital Structure
The EPS-EBIT approach to capital structure involves
selecting the capital structure that maximizes EPS over
the expected range of EBIT.
Using this approach, the emphasis is on maximizing the
owners returns (EPS).
A major shortcoming of this approach is the fact that
earnings are only one of the determinants of shareholder
wealth maximization.
This method does not explicitly consider the impact
of risk.

EBIT-EPS coordinates can be found by assuming specific

EBIT values and calculating the EPS associated with
them.
Such calculations for three capital structures: debt ratios of
0%, 30%, and 60% - for Cooke Company were
presented earlier in Table 12.2.
For EBIT values of $100,000 and $200,000, the
associated EPS values calculated are summarized in the
table with Figure 12.6.

EPS maximization is generally good for the

firms shareholders, the basic shortcoming
of this method is that it does not necessary
maximize shareholder wealth because it
fails to consider risk.

 If shareholders did not require risk

premiums (additional return) as the firm
increased its use of debt, a strategy
focusing on EPS maximization would
work.
To select the best capital structure, firms
must integrate both return (EPS) and risk
(required return).

Capital structure theory

(Brigham & Houston)
Teori struktur modal modern 1958 oleh
prof Franco Modigliani and Merton
Miller (MM).
MM proved, under a question-able set
of assumptions, that a firms value
should be unaffected by its capital
structure.

The assumptions:
1.
2.
3.
4.

There are no brokerage costs

There are no taxes
There are no bankruptcy costs
Investors can borrow at the same rate as
corporations
5. All investors have the same information as
management about the firms future
investment opportunities
6. EBIT is no affected by the use of debt

Trade-Off Theory
The capital structure theory that states firms
trade off the tax benefits of debt financing
against problems caused by potential
bankrupcy.
Rasio hutang yang optimal akan
memaksimumkan nilai perusahaan, dan
perusahaan akan menyimbangkan antara
manfaat dari penggunaan hutang dengan
biaya kebangkrutan.

Signaling Theory
Symmetric information that everyone investors
and managers alike have the same
information about a firms prospects.
However, in fact managers often have better
information than outside investors. This is called
asymmetric information, and it has an important
effect on the optimal capital structure.

Suatu tindakan yang diambil manajemen

yang memberi petunjuk kepada investor
mengenai pandangan manajemen terhadap
prospek perusahaan.
Perusahaan yang prospeknya baik, akan
menghindari penjualan saham baru,
sedangkan perusahaan yang prospeknya
kurang baik, cenderung untuk menjual
saham/meanrik investor baru.
Jika harga saham saat ini overvalue, maka
manajemen akan berpikir untuk
menawarkan saham baru.

Pecking Order Theory

Perusahaan menyukai internal financing
(pendanaan dari laba yang ditahan), jika
pendanaan dari luar diperlukan, maka
perusahaan akan lebih dahulu
menerbitkan obligasi dan kemudian
saham baru.