Leverage and Capital Structure (Modul MKL 2010-2011)

LEVERAGE AND CAPITAL STRUCTURE

BRIEF CONCEPT

Leverage results from the use of fixed-costs assets or funds to magnify returns to the firm’s owners.

Operating leverage is the potential use of fixed operating costs to magnify the effect of changes in sales on the firm’s earnings before interest and taxes.

Financial leverage is the potential use of fixed financial costs to magnify the effect of changes in earnings before interest and taxes on the firm’s earnings per share.

Business Risk and Financial Risk

Business risk is an uncertainty about future operating income (EBIT), determined by :

• Uncertainty about demand (sales)

• Uncertainty about output prices

• Uncertainty about costs

• Product, other types of liability

• Operating leverage 

Business risk depends on business factors such as competition, product liability, and operating leverage.

Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage. 

Financial risk depens only on the types of securities issued.

• More debt, more financial risk.

• Concentrates business risk on stockholders.

OPTIMAL CAPITAL STRUCTURE

Capital structure is the mix of long-term debt and equity maintained by the firm.

Optimal Capital Structure - that mix of debt and equity which maximizes the value of the firm (maximizes stock prices) or minimizes the cost of capital (WACC).

 

where :

EBIT                   =  earning before interest and taxes

T                          = tax rate

NOPAT               = net operating profits after taxes

r_a                          = weighted average cost of capital

• Target Capital Structure is simply defined as the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this target capital structure.

•  Pecking Order Theory is a theory that states companies prioritize their sources of financing (from internal financing to equity) according to the principle of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required.

• Signalling theory is based on the assumption that information is not equally available to all parties at the same time, and that information asymmetry is the rule. Information asymmetries (see also asymmetry – issuer/investor) can result in very low valuations or a sub-optimum investment policy. Signalling theory states that corporate financial decisions are signals sent by the company's managers to investors in order to shake up these asymmetries. These signals are the cornerstone of financial communications policy.

Factors to consider when establishing the firm’s target capital structure :

1.  Industry average debt ratio

2.  TIE ratios under different scenarios

3.  Lender/rating agency attitudes

4.  Reserve borrowing on control

5.  Asset structure

6.  Effect of financing on control

7.  Expected tax rate