Capital Structure Capital structure : The combination of debt and equity used

to finance a firm.
Target capital structure : The mix of debt, preferred stock and common equity
with which the firm plans to finance its investments.
Optimal Capital Structure : Optimal capital structure is the one that strikes a
balance between risk & return to achieve ultimate goal of maximizing the price
of the stock.

# Four primary factors influence the capital structure decisions

1. Business Risk (BR) : The firms BR , or riskiness that would be inherent in the
firms operations if it is used no debt. The greater the firms business risk, the
lower the amount of debt that that is optimal.
2. Tax position : A major reason for using debt is that interest is tax deductible,
which lowers the effective cost of debt.
3. Financial Flexibility : The ability to raise capital on reasonable terms under
adverse conditions.
4. Debt determining factor has to do with managerial attitude
(conservatism or aggressiveness) with regard to borrowing . Some
firms are more inclined to use debt in an effort to boost profits.

















































## Business risk : is defined as the uncertainty inherent in
projections of future returns, either on assets or on equity (ROE) , if
the firm use no debt .


## Financial risk : The portion of stockholders risk ,over and above
basic business risk, resulting from the manner in which the firm is
financed.

Financial risk results from using financial leverage, which exists
when a firm uses fixed income securities, such as debt and preferred
stock , to raise capital.

## Degree of Operating Leverage (DOL) is defined as the percentage
change in operating income (EBIT) associated with a given
percentage change in sales. DOL is concerned with the upper portion
of the Income Statement.
DOL Q = Q ( PV )____
Q ( P V ) F

DOL S = S VC___ = Gross Profit
S VC F EBIT

























Degree of Financial Leverage (DFL) : The percentage
change in earnings available to common stockholders
associated with a given percentage in earnings before
interest and taxes. DFL is concerned with lower part of
the Income Statement . DFL indicates about the
proportion of fixed financial obligation exists in the
firms operation

DFL = Percentage change in EPS = EBIT___
EPS EBIT I

































# Degree of Total Leverage : The percentage change in
EPS that results from a given percentage change in
sales ;DTL shows the effects of both operating leverage
and financial leverage.

DTL = ( DOL) X ( DFL )

DTL = Q (P V )__
Q (P-V) F- I
DTL = ___S VC___ = Gross Profit
S VC F- I EBIT - I

NOTE : I = Interest
VC = Variable Cost
F = Fixed Cost
S = Sales






































MATH
Capital Structure , effect of debt on the EPS

Given the following information, calculate (i)
the Earnings Per Share (EPS) and (ii) Expected
Earnings Per Share (iii) Degree of Operating Leverage
(DOL) (iv) Degree of Financial Leverage (DFL) of ABC
Company for 2002 if :
(i) Debt / Assets = 0%, (ii) Debt / Assets = 50%

Probability of Indicated sales 0.2 0.6 0.2
Sales (thousand) $ 200 $400 $600
Fixed Cost (thousand (80) (80) (80)
Variable Cost (thousand (120) (240) (360)
Total Cost (Except I nterest) (200) (320 ) (440)

EBIT 00 80 160













Assume the following:

(I)The firm is in the 40 percent tax bracket
(ii)Cost of debt is 12 percent
(iii)The value per share of ABC Company is $ 20
(iv)Total Capital of ABC Company is $ 200000