Summary Capital Structure

MODULE 12: CAPITAL STRUCTURE
Capital Restructuring
 How changes in capital structure affect firm value
 Involves changing amount of leverage a firm has without changing the firms assets
- Increase leverage: issue new debt; repurchase outstanding shares; increase dividends
- Decrease leverage: issue new shares; retire outstanding debt; decrease dividends
 Choose capital structure that maximises shareholder wealth by:
a. Maximising firm value
b. Minimise WACC

Business Risk
 Risk relating to operations of firm (nature of industry/product range)
 Many business risks are out of managers control

Leverage (magnifies returns & risk)
 Effects of fixed costs have on return shareholders earn
 Fixed costs have to be paid regardless (operating/financial costs)
 Limit negative impact of leverage; adopt strategies that are less reliant on fixed costs
E.g.
 Manufacture products or outsource (operating leverage)
 Adopt optimal capital structure (financial leverage)
 Lease/borrow and buy asset (financial leverage)

Operating leverage
 Concerned with relationship between firm sales and EBIT
 Large fixed operating costs: small changes in revenue = larger change in EBIT
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐸𝐵𝐼𝑇

Financial Risk and Financial Leverage
Financial risk arises from the use of debt in capital structure (interest and capital risk)
Financial leverage refers to the use of debt in capital structures to magnify returns concerned with
relationship between EBIT and EPS.
Large fixed interest costs: small change in EBIT = large change in EPS

Use of debt will cause PAT/ EPS to be levered/geared:
 Upwards (+): in economic upswing
 Downwards (-): in economic downturns

Optimal Capital Structure
Debt-equity ratio resulting in lowest WACC (maximizing firm value)