Capital structure and leverage are crucial concepts in finance, shaping how companies fund operations and manage risk. This unit explores the mix of debt and equity financing, theories behind capital structure decisions, and the impact of leverage on firm value and performance.
Students will learn about financial ratios, risk-return trade-offs, and optimal capital structure. The unit also covers real-world applications, helping students understand how these concepts influence corporate financial decisions and investor analysis in practice.
Capital structure refers to the mix of debt and equity financing a company uses to fund its operations and growth
Debt financing involves borrowing money from lenders (banks, bonds) that must be repaid with interest
Equity financing involves selling ownership stakes in the company to investors in exchange for capital
Leverage measures the degree to which a company uses debt financing relative to equity financing
Higher leverage means a greater proportion of debt financing
Financial leverage refers to the use of debt to increase the potential return on equity
Operating leverage refers to the proportion of fixed costs relative to variable costs in a company's cost structure
Weighted Average Cost of Capital (WACC) represents the average cost of all sources of capital (debt and equity) weighted by their respective proportions
Capital Structure Theories
Modigliani-Miller (MM) theorem proposes that in a perfect capital market, a firm's value is independent of its capital structure
Assumes no taxes, no transaction costs, no bankruptcy costs, and symmetric information
Trade-off theory suggests that firms balance the benefits of debt (tax shield) against the costs of debt (financial distress and bankruptcy costs) to determine an optimal capital structure
Pecking order theory argues that firms prefer internal financing (retained earnings) over external financing and debt over equity when external financing is necessary due to information asymmetry
Agency theory considers the conflicts of interest between shareholders and managers (agency costs) and how capital structure can be used to mitigate these conflicts
Market timing theory proposes that firms issue equity when market valuations are high and debt when market valuations are low to take advantage of temporary mispricing
Signaling theory suggests that capital structure decisions can convey information about a firm's future prospects to investors
Types of Leverage
Financial leverage refers to the use of debt financing to magnify returns to equity holders
Increases potential returns but also increases financial risk and the possibility of bankruptcy
Operating leverage refers to the proportion of fixed costs relative to variable costs in a company's cost structure
Higher operating leverage means greater sensitivity of operating income to changes in sales
Combined leverage is the product of financial leverage and operating leverage and measures the total impact of leverage on a firm's earnings per share (EPS)
Degree of Operating Leverage (DOL) measures the percentage change in operating income for a given percentage change in sales
Degree of Financial Leverage (DFL) measures the percentage change in EPS for a given percentage change in operating income
Degree of Combined Leverage (DCL) is the product of DOL and DFL and measures the percentage change in EPS for a given percentage change in sales
Calculating Financial Ratios
Debt-to-Equity Ratio = Total Debt / Total Equity
Measures the proportion of debt financing relative to equity financing
Debt-to-Assets Ratio = Total Debt / Total Assets
Measures the proportion of assets financed by debt
Interest Coverage Ratio = EBIT / Interest Expense
Measures a firm's ability to meet its interest obligations from operating income