Chapter 11
Leverage
and Capital
Structure
Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Ch 11 Learning Goals
1. Causes & measures of operating, financial, and
total leverage.
2. Business, financial & total risk.
3. Optimal capital structure.
11-2
Leverage
• A change in sales revenue often causes a
bigger percentage change in earnings.
– Cause: fixed costs
– Name: “leverage”
11-3
Leverage
• Kinds of leverage (& causes):
– Operating leverage (fixed operating costs)
– Financial leverage (fixed financing costs)
– Total leverage (the product of the other two)
• Generally, higher leverage means:
– Increased risk.
– Increased potential return.
11-4
Operating Leverage
Table 11.4 The EBIT for Various Sales Levels
11-5
Measuring Operating Leverage: the
Degree of Operating Leverage
• The degree of operating leverage (DOL) measures the
sensitivity of EBIT to changes in Sales.
• A company’s DOL can be calculated two different
ways:
– point estimate
– interval estimate
11-6
Financial Leverage
Table 11.6 The EPS for Various EBIT Levelsa
11-7
Measuring Financial Leverage: the
Degree of Financial Leverage
• The degree of financial leverage (DFL) measures the
sensitivity of EPS to changes in EBIT.
• Like DOL, DFL can be calculated two different ways:
– point estimate
– interval estimate
11-8
Total Leverage
• Total leverage can be viewed as the total
impact of the fixed costs in the firm’s operating
and financial structure.
• The relationship between DOL, DFL and DTL is
illustrated by the following equation:
DTL = DOL X DFL
11-9
The Firm’s Capital Structure
• The firm’s capital structure is the mix of debt and
equity it uses to finance fixed assets.
• The optimal capital structure for a particular firm
depends on:
– its business risk
– the risk tolerance of its owners & managers
11-10
Determinants of Business Risk
High business risk is the result of
high fixed operating costs (high DOL)
unstable demand for firm’s products
volatile costs (raw materials, for example)
11-11
Financial Risk
• Financial risk is the risk that the firm cannot meet its
financial obligations & is the result of debt financing.
• The total risk a firm faces and the probability of
bankruptcy are the result of both business risk and
financial risk.
• Firms with high business risk should use less debt
financing. As a result, the optimal capital structure is
not the same for all industries or firms.
11-12
Optimal Capital Structure
• Although higher EPS is generally good for the
firm’s shareholders, the optimal capital structure
is not usually the one that maximizes EPS. We
must also consider the impact of the capital
structure on the firm’s risk.
11-13
Optimal Capital Structure (cont.)
Figure 11.6
Estimating Value
11-14
Optimal Capital Structure
• The optimal capital structure results in:
– Minimum WACC
– Maximum stock price
11-15