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Unit 2 of 4 · B.Com Sem 5

Unit 2: Capital structure & leverage

Financial Management notes · PTU syllabus (BCOM 501-18)

3 min read5 topics10 exam questions
On this page
  1. Unit summary
  2. Capital structure: meaning and features
  3. Factors affecting capital structure
  4. Theories of capital structure
  5. EBIT–EPS analysis
  6. Operating and financial leverage
  7. Key terms
  8. Quick revision
  9. Important questions

Unit summary

The mix of debt and equity affects both risk and return. This unit covers the meaning and features of capital structure decisions, factors affecting capital structure, the theories of capital structure, EBIT–EPS analysis, and operating and financial leverage.

After this unit you can

  • Explain the meaning and features of an optimal capital structure
  • Explain the factors affecting capital structure
  • Explain NI, NOI, traditional and MM theories of capital structure
  • Perform EBIT–EPS analysis and compute operating, financial and combined leverage

PTU syllabus topics

  • Meaning and features of capital structure decisions
  • factors affecting capital structure
  • theories of capital structure
  • EBIT-EPS analysis
  • financial and operating leverage
Key formulasLeverage

  • Operating leverage

    Contribution / EBIT

  • Financial leverage

    EBIT / EBT

  • Combined leverage

    Operating leverage × financial leverage

  • EPS

    (EBIT − interest)(1 − tax) / number of shares

1

Topic 1

Capital structure: meaning and features

Capital structure is the mix of long-term sources of funds — equity share capital, preference share capital, reserves and long-term debt.

  • Optimal capital structure: the mix that minimises WACC and maximises the value of the firm.
  • Features of a sound capital structure: profitability, solvency (limited debt), flexibility, control (avoid dilution), conservatism, simplicity.
  • Trading on equity: using fixed-cost funds (debt, preference) to increase return on equity when the return on assets exceeds the cost of debt.
2

Topic 2

Factors affecting capital structure

ClassificationDeterminants of capital structure
Capital structure

  • Internal factors

    Cash flow position, cost of capital, risk appetite, control considerations, size and age of firm, asset structure

  • External factors

    Capital market conditions, interest rates, tax rates, regulatory norms (SEBI, RBI), lenders' policies

  • Business factors

    Stability of sales and earnings, growth rate, nature of industry

  • Stable cash flows and tangible assets support more debt (utilities, infrastructure); volatile businesses use more equity (technology start-ups).
3

Topic 3

Theories of capital structure

ComparisonCapital structure theories
Value depends on leverage?
Key idea

Net Income (NI) approach — Durand

Yes

Kd and Ke constant; more debt lowers WACC and raises value

Net Operating Income (NOI) approach — Durand

No

WACC constant; Ke rises with debt, offsetting cheap debt

Traditional approach

Yes, up to a point

Moderate debt lowers WACC; excessive debt raises it — optimal structure exists

Modigliani–Miller (1958, no taxes)

No

Arbitrage keeps value equal for levered and unlevered firms

MM with taxes (1963)

Yes

Interest tax shield: VL = VU + tD

Example

NI approach: EBIT ₹2,00,000; debt ₹5,00,000 at 10%; Ke 12.5%. Earnings for equity = 1,50,000; value of equity = 1,50,000 ÷ 0.125 = ₹12,00,000; value of firm = ₹17,00,000; overall cost = 2,00,000 ÷ 17,00,000 = 11.76%.

  • MM assumptions: perfect capital markets, no transaction costs, homogeneous expectations, same risk class, 100% payout, no taxes (1958). Arbitrage process equalises values.
  • Trade-off theory: balances tax benefits of debt against bankruptcy and agency costs. Pecking order theory: firms prefer internal funds, then debt, then equity.
4

Topic 4

EBIT–EPS analysis

EBIT–EPS analysis compares financing plans by their effect on EPS at various levels of EBIT.

Key formulasEBIT–EPS formulas

  • EPS

    [(EBIT − I)(1 − t) − Preference dividend] ÷ Number of equity shares

  • Indifference point (equity vs debt)

    [(X − I1)(1 − t)] ÷ N1 = [(X − I2)(1 − t)] ÷ N2

Example

Need ₹10 lakh. Plan A: all equity (1,00,000 shares of ₹10). Plan B: ₹5 lakh equity (50,000 shares) + ₹5 lakh debt at 10%. Tax 30%. At EBIT ₹2,00,000: EPS A = 1,40,000 ÷ 1,00,000 = ₹1.40; EPS B = (2,00,000 − 50,000) × 0.7 ÷ 50,000 = ₹2.10. Indifference point: X ÷ 1,00,000 = (X − 50,000) ÷ 50,000 → X = ₹1,00,000. Above ₹1 lakh EBIT, debt gives higher EPS.

5

Topic 5

Operating and financial leverage

Key formulasLeverage formulas

  • Contribution

    Sales − Variable cost

  • Degree of operating leverage (DOL)

    Contribution ÷ EBIT

  • Degree of financial leverage (DFL)

    EBIT ÷ (EBIT − Interest − Preference dividend ÷ (1 − t))

  • Degree of combined leverage (DCL)

    DOL × DFL = Contribution ÷ EBT

Example

Sales ₹10,00,000; variable cost ₹6,00,000; fixed cost ₹2,00,000; interest ₹50,000. Contribution = 4,00,000; EBIT = 2,00,000; EBT = 1,50,000. DOL = 2; DFL = 1.33; DCL = 2.67 — a 10% rise in sales raises EPS by about 26.7%.

ComparisonOperating vs financial leverage
Operating leverage
Financial leverage

Arises from

Fixed operating costs

Fixed financial charges (interest)

Measures

Effect of sales change on EBIT

Effect of EBIT change on EPS

Risk

Business risk

Financial risk

Controlled by

Cost structure

Capital structure

Exam tip

High DOL with high DFL is dangerous — a small fall in sales can wipe out EPS. Firms usually balance one high with one low.

Key terms

Capital structure
Mix of long-term sources of funds
Optimal capital structure
Mix that minimises WACC and maximises firm value
Trading on equity
Using debt to increase returns to equity shareholders
Indifference point
EBIT at which two financing plans give the same EPS
Financial leverage
Use of fixed-charge funds to magnify EPS

Quick revision

  • Optimal structure minimises WACC.
  • NI (relevant), NOI (irrelevant), traditional (optimal exists), MM (irrelevant without taxes).
  • EBIT–EPS: debt better above the indifference point.
  • DOL = C/EBIT; DFL = EBIT/EBT; DCL = C/EBT.
  • Operating leverage → business risk; financial leverage → financial risk.

Important exam questions

Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).

Short-answer questions

  1. Q1.What is capital structure?
  2. Q2.What is trading on equity?
  3. Q3.State the NOI approach.
  4. Q4.What is the MM hypothesis?
  5. Q5.What is an indifference point?
  6. Q6.Define degree of operating leverage.

Long-answer questions

  1. Q1.Explain the factors determining capital structure.
  2. Q2.Explain the NI, NOI, traditional and MM theories of capital structure.
  3. Q3.Explain EBIT–EPS analysis with an illustration.
  4. Q4.Explain operating, financial and combined leverage with examples.

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