Financing Decisions & Leverage

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Capital Structure The mix of debt and equity used to finance a company's assets. It affects the firm's risk and return, and thus its value. Objective: Maximize firm value and minimize the WACC. Trade-off Theory: Balances the benefits of debt (tax shield) against its costs (financial distress). Pecking Order Theory: Firms prefer internal financing, then debt, then equity as a last resort. Factors Influencing Capital Structure: Business risk, tax position, financial flexibility, management attitude, lender/rating agency attitudes. Cost of Capital The rate of return that a company must earn on an investment project to maintain its market value and attract new capital. Cost of Equity ($K_e$): Dividend Discount Model (DDM): $K_e = \frac{D_1}{P_0} + g$ CAPM: $K_e = R_f + \beta(R_m - R_f)$ Cost of Debt ($K_d$): Pre-tax cost of new debt, often approximated by yield to maturity (YTM). After-tax Cost of Debt: $K_d(1-T)$, where $T$ is the corporate tax rate. Cost of Preferred Stock ($K_p$): $K_p = \frac{D_p}{P_0}$ Weighted Average Cost of Capital (WACC): $$WACC = (E/V)K_e + (D/V)K_d(1-T) + (P/V)K_p$$ Where $E$=Market value of equity, $D$=Market value of debt, $P$=Market value of preferred stock, $V=E+D+P$. Valuation The process of determining the economic value of an asset or a company. Capital structure and cost of capital are critical inputs. Discounted Cash Flow (DCF) Valuation: Firm value is the present value of future free cash flows (FCF) discounted at the WACC. $Firm Value = \sum_{t=1}^{n} \frac{FCF_t}{(1+WACC)^t} + \frac{Terminal Value}{(1+WACC)^n}$ $FCF = EBIT(1-T) + Depreciation - Capital Expenditures - \Delta NWC$ Adjusted Present Value (APV) Valuation: Values the company as if it were all-equity financed, and then adds the present value of the tax shield benefits of debt. $APV = Value_{Unlevered} + PV(Tax Shields)$ Leverage Analysis The use of fixed costs in a firm's cost structure or capital structure to magnify the effects of changes in sales on earnings per share. Degree of Operating Leverage (DOL) Measures the sensitivity of operating income (EBIT) to changes in sales revenue. Higher DOL means higher business risk. Formula: $$DOL = \frac{\% \Delta EBIT}{\% \Delta Sales} = \frac{Q(P-V)}{Q(P-V)-F} = \frac{Sales - Variable Costs}{EBIT}$$ Where $Q$=Quantity, $P$=Price per unit, $V$=Variable cost per unit, $F$=Fixed operating costs. Interpretation: A DOL of 2 means a 1% change in sales leads to a 2% change in EBIT. Degree of Financial Leverage (DFL) Measures the sensitivity of earnings per share (EPS) to changes in operating income (EBIT). Higher DFL means higher financial risk due to fixed interest payments. Formula: $$DFL = \frac{\% \Delta EPS}{\% \Delta EBIT} = \frac{EBIT}{EBIT - Interest - \frac{Preferred Dividends}{1-T}}$$ Interpretation: A DFL of 1.5 means a 1% change in EBIT leads to a 1.5% change in EPS. Degree of Combined Leverage (DCL) Measures the sensitivity of earnings per share (EPS) to changes in sales revenue. It combines both operating and financial leverage. Formula: $$DCL = DOL \times DFL = \frac{\% \Delta EPS}{\% \Delta Sales} = \frac{Q(P-V)}{Q(P-V)-F-Interest - \frac{Preferred Dividends}{1-T}}$$ $$DCL = \frac{Sales - Variable Costs}{EBIT - Interest - \frac{Preferred Dividends}{1-T}}$$ Interpretation: A DCL of 3 means a 1% change in sales leads to a 3% change in EPS.