Financial Mathematics Unit III

Capital Structure

The capital structure is how a firm finances its overall operations and growth by using different sources
of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. Short-term debt such as working capital
requirements is also considered to be part of the capital structure.

Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations
and finance its assets. The structure is typically expressed as a debt-to-equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions, and
other investments. There are tradeoffs firms have to make when they decide whether to raise debt or
equity and managers will balance the two try and find the optimal capital structure.

Optimal Capital Structure

The optimal capital structure of a firm is often defined as the proportion of debt and equity that result in
the lowest weighted average cost of capital (WACC) for the firm. This technical definition is not always
used in practice, and firms often have a strategic or philosophical view of what the structure should be.

Debt investors take less risk because they have the first claim on the assets of the business in the event
of bankruptcy. For this reason, they accept a lower rate of return, and thus the firm has a lower cost of
capital when it issues debt compared to equity.

Equity investors take more risk as they only receive the residual value after debt investors have been
repaid. In exchange for this risk equity investors expect a higher rate of return and therefore the
implied cost of equity is greater than that of debt.

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 Financial Mathematics Unit III

Capital Structure Theories

NET INCOME APPROACH

This approach was suggested by Durand and he was in the favor of financial leverage decision. According
to him, change in financial leverage would lead to a change in the cost of capital. In short, if the ratio of
debt in the capital structure increases, the weighted average cost of capital decreases and hence the
value of the firm.

NET OPERATING INCOME APPROACH

This approach is also provided by Durand but it is totally opposite to the Net Income Approach. It says
that the weighted average cost of capital remains constant. It believes in the fact that the market
analyses firm as a whole which discounts at a particular rate which is not related to debt-equity ratio.

TRADITIONAL APPROACH

This approach is not defined hard and fast facts but it says that cost of capital is a function of the capital
structure. The special thing about this approach is that it believes an optimal capital structure. Optimal
capital structure implies that at a particular ratio of debt and equity, the cost of capital is minimum and
value of the firm is maximum.

MODIGLIANI AND MILLER APPROACH (MM APPROACH)

It is a capital structure theory named after Franco Modigliani and Merton Miller. MM theory proposed
two propositions.

Proposition I: It says that the capital structure is irrelevant to the value of a firm. The value of two
identical firms would be same and it would not be affected by the mode of finance adopted to finance
the assets. The value of a firm is dependent on the expected future earnings.

Proposition II: It says that the financial leverage boosts the expected earnings but it does not increase
the value of the firm because the increase in earnings is compensated by the change in the required rate
of return.

To summarize, it is essential for finance professionals to know about the nitty-gritty of capital structure
they have suggested to the management. Accurate analysis of capital structure can help a company save
on the part of their cost of capital and hence improve profitability for the shareholders.

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 Financial Mathematics Unit III

Financial Leverage

Financial leverage is the degree to which a company uses fixed-income securities such as debt
and preferred equity. The more debt financing a company uses, the higher its financial
leverage. A high degree of financial leverage means high interest payments, which negatively
affect the company's bottom-line earnings per share.
Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred
equities in a company's capital structure. As a company increases debt and preferred equities,
interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A
company should keep its optimal capital structure in mind when making financing decisions to
ensure any increases in debt and preferred equity increase the value of the company.
Financial Leverage can be calculated by the following formula

EBIT or Operating profit

𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
EBT or taxable income
Percentage change in EPS
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
Percentage change in EBIT

Operating Leverage

Operating leverage is a measurement of the degree to which a firm or project incurs a

combination of fixed and variable costs. A business that makes sales providing a very high gross
margin and fewer fixed costs and variable costs has much leverage. The higher the degree of
operating leverage, the greater the potential danger from forecasting risk, where a relatively
small error in forecasting sales can be magnified into large errors in cash flow projections.

Operating Leverage = Contribution Margin / Net Operating Income

Operating leverage may be used for calculating a company’s breakeven point and substantially
affecting profits by changing its pricing structure. Because businesses with higher operating
leverage do not proportionately increase expenses as they increase sales, those companies may
bring in more revenue than other companies. However, businesses with high operating
leverage are also more affected by poor corporate decisions and other factors that may result
in revenue decreases.

High and Low Operating Leverage

It is essential to compare operating leverage among companies in the same industry, as some
industries have higher fixed costs than others. The concept of a high or low ratio is then more
clearly determined.

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 Financial Mathematics Unit III

Most of a company’s costs are fixed costs that occur regardless of sales volume. As long as a
business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs
are covered and profits are earned. Other company costs are variable costs incurred when sales
occur. The business earns less profit on each sale but needs a lower sales volume for covering
fixed costs. However, the business does not generate greater profits unless it increases its sales
volume.

For example, a software business has greater fixed costs in developers’ salaries, and lower
variable costs with software sales. Therefore, the business has high operating leverage. In
contrast, a computer consulting firm charges its clients hourly, resulting in variable consultant
wages. Therefore, the business has low operating leverage.