Question

1. Capital Structure

a. What is it?
b. Why is it important?
c. What is operating leverage? Financial leverage? How are they measured? d. How does each impact a firm’s capital structure?
e. What is a firm’s optimal capital structure

Answer 1

1.

a) Capital structure refers to an arrangement whereby a Company finances its assets through various sources of finance like equity, debt, preference capital etc. The proportion of each source of finance depends on the financial policy of the particular Company, i.e, its risk apetite, control dilution level etc. This entire set of decisions entailing the proportion of various sources of finance is known as capital structure decisions.

b) Capital structure is important due to the following reasons:

1. Proper mix of funds ensures that the Company is able to minimize its cost of capital, i.e, WACC.

2. Helps in maximising the value of the Firm; due to effective mix of funds and lower WACC.

3. Helps in maximising the share price owing to Firm Value Maximisation, increasing dividend receipts of shareholders etc.

4. Increases the ability of a Company to invest in profitable projects and assets which will bring long term benefits for the Firm.

c) Operating leverage: It measures the extent to which EBIT or Operating Profit of a Company can be increased by increasing the revenue. It also measures the extent of debt used by the Company to fund its operations. A high Operating Leverage shows the presence of higher levels of Fixed Costs in the Company.

Formula: Operating leverage= Contribution / EBIT OR % change in EBIT / % change in sales

Financial Leverage: measures the presence of debt in the capital structure of a Company to finance assets. A higher FL shows that the company is highly geared and has higher levels of financial risk. It also shows how much the PAT of a Company will change due to a change in EBIT.

Formula: EBIT/ Profit before tax    % change in PAT / % change in EBIT

d) High Operating leverage means higher fixed costs or debt in the capital structure of a Firm. Higher degree of operating leverage rises the risk of cash flow problems that results from errors in forecasts of future sales. Operating Leverage directly impacts the operating profits of a Firm.

High Financial Leverage means the company is using higher amounts of debt to fund its long term assets. This means higher levels of financial risk/ gearing for the Company. On a positive side, if a firm is able to generate a higher return on investment (ROI) than the interest rate it is paying, leverage will have its positive effect shareholder’s return.

e) Optimal Capital Structure refers to the capital structure with an effective combination of debt and equity which takes care of both ends:

1. maximizes the Company's market value and increasing shareholders' wealth

2. minimizing the Company's cost of capital, i.e WACC.