Capital Structure -Chapter 16, Eugene Brigham-General
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Transcript of Capital Structure -Chapter 16, Eugene Brigham-General
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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 solelycapital 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
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How capital structure decision affect WACC/FCF?
1. Debt increase the cost of stock2. Debt reduces the taxes a company pays
3.The risk of bankruptcy increases the cost of debt
4. The net effect of WACC5. Bankruptcy cost reduces free cash flow
6.Bankruptcy risk affects agency cost
7. Issuing equity conveys a signal to the market place
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Business risk vs. financial risk
1. Business risk: is the risk inherent in its operation.
It is the risk that a firms common stockholderswould 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.
2. 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 agiven 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 withthe owners equity in the capital structure is referred to as thefinancial leverage orgearing ortrading on equity.
Measures of FL:
1. Debt ratio: the ratio of debt to total capital
L1 = D/(D+E)
= D/V2. Debt equity ratio: The ratio of debt to equity.
L2 = D/E
3. Interest coverage ratio: the ratio of net operatingincome (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 givenpercentage 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 totalleverage on EPS. The degree of combined leverage is given asfollows:
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 lacB 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 Tk. 1,120 lacPBT Tk. 320 lac
Fixed cost Tk. 700 lac
Required:
a. DOL, DFL, DCL
d. Calculate the percentage changes in EPS if sales
is increased by 5 percent.