BUSINESS & FINANCE STUDY NOTES
CAPITAL STRUCTURE
AND LEVERAGE
DOL • DFL • EBIT-EPS • Modigliani-Miller
Formulas • Solved Examples • Practice Questions
Break-even Indifference EBIT Tax Shield Optimal Structure
9 Pages | Quick Revision | Exam Ready
, CAPITAL STRUCTURE AND LEVERAGE Business & Finance Study Notes
1. What is Capital Structure?
Capital structure is the mix of debt, preferred stock and common equity a firm uses to finance its assets. The
optimal capital structure is the mix that minimises the WACC and maximises the value of the firm. Using debt
gives a tax saving and may raise earnings per share, but it also adds fixed costs and risk.
Business Risk vs Financial Risk
Business risk Financial risk
Uncertainty about operating income (EBIT) even Extra risk to shareholders from using debt and
Meaning
with no debt preferred stock
Fixed interest and preferred dividends (financial
Caused by Demand, competition, costs, operating leverage
leverage)
Who bears it All investors in the firm Mainly the common shareholders
Three Kinds of Leverage
Leverage Fixed cost involved What it magnifies Measure
Fixed operating costs (rent, salaries, Change in sales into change in
Operating leverage DOL
depreciation) EBIT
Fixed financing costs (interest, Change in EBIT into change in
Financial leverage DFL
preferred dividends) EPS
Total (combined) Change in sales into change in
Both DTL = DOL x DFL
leverage EPS
Leverage works both ways: when sales or EBIT rise, profits rise faster; when they fall, profits fall faster, and the risk of loss and
bankruptcy grows.
Factors Affecting the Capital Structure Decision
• Business risk: firms with unstable earnings should use less debt.
• Tax rate: a higher tax rate makes the interest tax shield more valuable.
• Asset type: firms with tangible assets that can be pledged find it easier to borrow.
• Profitability, growth and flexibility: profitable firms can fund themselves from retained earnings; firms keep
spare borrowing capacity for the future.
• Control: issuing new shares may dilute the owners' control; debt does not.
Main Theories
Theory Key idea
In perfect markets with no taxes, capital structure does not affect firm value. With corporate
Modigliani-Miller (MM)
taxes, debt adds value through the interest tax shield.
Firms balance the tax benefit of debt against the cost of financial distress. There is an optimal
Trade-off theory
debt level.
Firms prefer internal funds first, then debt, and new equity last (because of information
Pecking order theory
differences between managers and investors).
Page 2 of 9
CAPITAL STRUCTURE
AND LEVERAGE
DOL • DFL • EBIT-EPS • Modigliani-Miller
Formulas • Solved Examples • Practice Questions
Break-even Indifference EBIT Tax Shield Optimal Structure
9 Pages | Quick Revision | Exam Ready
, CAPITAL STRUCTURE AND LEVERAGE Business & Finance Study Notes
1. What is Capital Structure?
Capital structure is the mix of debt, preferred stock and common equity a firm uses to finance its assets. The
optimal capital structure is the mix that minimises the WACC and maximises the value of the firm. Using debt
gives a tax saving and may raise earnings per share, but it also adds fixed costs and risk.
Business Risk vs Financial Risk
Business risk Financial risk
Uncertainty about operating income (EBIT) even Extra risk to shareholders from using debt and
Meaning
with no debt preferred stock
Fixed interest and preferred dividends (financial
Caused by Demand, competition, costs, operating leverage
leverage)
Who bears it All investors in the firm Mainly the common shareholders
Three Kinds of Leverage
Leverage Fixed cost involved What it magnifies Measure
Fixed operating costs (rent, salaries, Change in sales into change in
Operating leverage DOL
depreciation) EBIT
Fixed financing costs (interest, Change in EBIT into change in
Financial leverage DFL
preferred dividends) EPS
Total (combined) Change in sales into change in
Both DTL = DOL x DFL
leverage EPS
Leverage works both ways: when sales or EBIT rise, profits rise faster; when they fall, profits fall faster, and the risk of loss and
bankruptcy grows.
Factors Affecting the Capital Structure Decision
• Business risk: firms with unstable earnings should use less debt.
• Tax rate: a higher tax rate makes the interest tax shield more valuable.
• Asset type: firms with tangible assets that can be pledged find it easier to borrow.
• Profitability, growth and flexibility: profitable firms can fund themselves from retained earnings; firms keep
spare borrowing capacity for the future.
• Control: issuing new shares may dilute the owners' control; debt does not.
Main Theories
Theory Key idea
In perfect markets with no taxes, capital structure does not affect firm value. With corporate
Modigliani-Miller (MM)
taxes, debt adds value through the interest tax shield.
Firms balance the tax benefit of debt against the cost of financial distress. There is an optimal
Trade-off theory
debt level.
Firms prefer internal funds first, then debt, and new equity last (because of information
Pecking order theory
differences between managers and investors).
Page 2 of 9
