CAPITAL STRUCTURE : Chapter 16 (Eugene Brigham)

Capital structure:
The debt-equity mix of firm is called capital structure. It is is the composition of the long term sources of finance of a company. The sources of long term finance are of equity finance (e.g. common stock, premium, reserve & surplus/retained earnings) and debt finance (e.g. debenture, bond, preferred stock etc). Net working capital is not considered when solely capital structure is meant

Financial structure:
When working capital is considered along with the capital structure, it is called financial structure.

Optimum capital structure:

The capital structure at which, the (weighted average) cost of capital is the least and the market value of the share is the highest, that capital structure is called the optimum capital structure. When the marginal real cost of all the sources of capital 1

How capital structure decision affect WACC/FCF?

1. Debt increase the cost of stock 2. Debt reduces the taxes a company pays 3.The risk of bankruptcy increases the cost of debt 4. The net effect of WACC 5. Bankruptcy cost reduces free cash flow 6.Bankruptcy risk affects agency cost 7. Issuing equity conveys a signal to the market place

Business risk vs. financial risk

1.

2.

Business risk: is the risk inherent in its operation. It is the risk that a firms common stockholders would face if the firm had no debt. Business risk arises from uncertainty in projections of the firms cash flows, which in turn means uncertainty about its operating profit and its capital investment requirement. Financial risk: is the additional risk placed on the common stockholders as a result of the decision to finance with debt. Using leverage i.e. has both good and bad effects: higher leverage increases expected ROE but it also increases risk.
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Degree of operating leverage (DOL):

The percentage change in EBIT occurring due to a given percentage change in sales is referred to as the degree of operating leverage (DOL).

DFL = % changes in EBIT/% changes in sales =( EBIT/EBIT)/(Sales/Sales)

Alternative formula,

DFL = Contribution margin/EBIT = EBIT+ Fixed cost/EBIT = (EBIT/EBIT) +(Fixed cost/EBIT) = 1 + (Fixed cost/EBIT)
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Financial Leverage (FL)

The use of the fixed charges sources of fund (such as debt and preference) along with the owners equity in the capital structure is referred to as the financial leverage or gearing or trading on equity.

Measures of FL:

1. Debt ratio: the ratio of debt to total capital L1 = D/(D+E) = D/V 2. Debt equity ratio: The ratio of debt to equity. L2 = D/E

3. Interest coverage ratio: the ratio of net operating income (NOI) or EBIT to interest charge. L3 = EBIT/Interest
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Degree of financial leverage (DFL):

The percentage change in EPS occurring due to a given percentage change in EBIT is referred to as the degree of financial leverage (DFL).

DFL = % changes in EPS/% changes in EBIT =( EPS/EPS)/(EBIT/EBIT)

Alternative formula,

DFL

= EBIT/(EBIT-INT) = EBIT/PBT = (PBT+INT)/PBT = (PBT/PBT)+(INT/PBT) = 1 + (INT/PBT)

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Degree of combined leverage (DCL):

DFL and DOL can be combined to see the effect of total leverage on EPS. The degree of combined leverage is given as follows: DCL = DFL * DOL = (% changes in EPS/% changes in EBIT)* ( % changes in EBIT/% changes in sales) = % changes in EPS/% changes in sales =( EPS/EPS)/(Sales/Sales)
Alternative formula,

DCL

= CM/(EBIT-INT) = CM/PBT = (PBT+INT+FC/PBT) = PBT/PBT + (INT+FC/PBT) = 1+ (INT+FC)/PBT

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Example-1:

Two firms A and B have the following information: Firm Sales VC FC Tk. Tk. Tk. A 1,800 lac 450 lac 900 lac B 1,500 lac 750 lac 375 lac

Required:
a. Profit to sale ratio b. BEB c. DOL. d. If sales of the company is increased by 20%, by how much the profit will increase?
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Example-2:

Consider the following information for XYZ Ltd: Particulars Amount

EBIT PBT Fixed cost

Tk. 1,120 lac Tk. 320 lac Tk. 700 lac

Required:
a. DOL, DFL, DCL d. Calculate the percentage changes in EPS if sales is increased by 5 percent.
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