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EXAMPLE 11.3 From Example 11.1, assume that the Wayne Company is currently selling 6,000 doors per year.
Its operating leverage is:
($25  $15)(6,000)
  $60,000
(PV)X =
(P  V)X FC  ($25  $15)(6,000)  $50,000 10,000
which means if sales increase by 10 percent, the company can expect its net income to increase by six times that
amount, or 60 percent.
Financial Leverage
Financial leverage is a measure of financial risk and arises from fixed financial costs. One way to
measure financial leverage is to determine how earnings per share are affected by a change in EBIT (or
operating income).
 ( P  V ) X  FC
% change in EPS
Financial leverage at a given level of sales ( X ) =
YOchange in EBIT  (P  V)X  FC  IC
where EPS is earnings per share, and IC is fixed finance charges, i.e., interest expense or preferred stock
dividends. [Preferred stock dividend must be adjusted for taxes Le., preferred stock dividend/(l  t).]
307
CHAP. 1 1 LEVERAGE AND CAPITAL STRUCTURE
1
EXAMPLE 11.4 Using the data in Example 11.3, the Wayne Company has total financial charges of $2,000, half
in interest expense and half in preferred stock dividend. The corporate tax rate is 40 percent. What is their financial
leverage? First,
Therefore, Wayneâ€™s financial leverage is computed as follows:
 ($25  $15)(6,000) $50,000
(PV)XFC  $109000 1.36
=
(p  V)X  FC  IC  ($25  $15)(6,000) $50,000  $2,667 $7,333
which means that if EBIT increases by 10 percent, Wayne can expect its EPS to increase by 1.36 times, or by 13.6
percent.
Total Leverage
Total leverage is a measure of total risk. The way to measure total leverage is to determine how EPS
is affected by a change in sales.
% change in EPS
Total leverage at a given level of sales ( X ) =
% change in sales
= operating leverage X financial leverage
 (P  V)X  FC
(PV)X

(P  V)X FC (P  V)X  FC  IC
 (P  V ) X

(P  V)X FC  IC
EXAMPLE 11.5 From Examples 11.3 and 11.4, the total leverage for Wayne Company is:
Operating leverage X financial leverage = 6 X 1.36 = 8.16
or
($25  $15)(6,000)
(P  V)X
(P  V)X  FC  IC ($25  $15)(6,000) $50,000  $2,667
˜˜
 $60â€™000 8.18 (due to rounding error)
=
$7,333
11.3 THE THEORY OF CAPITAL STRUCTURE
The theory of capital structure is closely related to the f r â€™
i m scost of capital. Capital structure is the
mix of the longterm sources of funds used by the firm. The primary objective of capital structure
decisions is to maximize the market value of the firm through an appropriate mix of longterm sources
of funds. This mix, called the optimal capital structure, will minimize the firmâ€™s overall cost of capital.
However, there are arguments about whether an optimal capital structure actually exists. The arguments
center on whether a firm can, in reality, affect its valuation and its cost of capital by varying the mixture
of the funds used. There are four different approaches to the theory of capital structure:
Net operating income (NOI) approach
1.
Net income (NI) approach
2.
Traditional approach
3.
ModiglianiMiller (MM) approach
4.
308 LEVERAGE AND CAPITAL STRUCTURE [CHAP. 11
All four use the following simplifying assumptions:
1. No income taxes are included; they will be removed later.
2. The company makes a 100 percent dividend payout.
3. No transaction costs are incurred.
4. The company has constant earnings before interest and taxes (EBIT).
5. The company has a constant operating risk.
Given these assumptions, the company is concerned with the following three rates:
I
k, = 
1.
B
where ki = yield on the firmâ€™s debt (assuming a perpetuity)
I = annual interest charges
B = market value of debt outstanding
EAC
k, = 
2.
S
k, = the firmâ€™s required rate of return on equity or cost of common equity
where
(assuming no earnings growth and a 100 percent dividend payout ratio)
EAC = earnings available to common stockholders
S = market value of stock outstanding
EBIT
k, = 
3.
V
k, = the firmâ€™s overall cost of capital (or capitalization rate)
where
EBIT = earnings before interest and taxes (or operating earnings)
V = B + S and is the market value of the firm
In each of the four approaches to determining capital structure, the concern is with what happens
to k i ,k,, and k, when the degree of leverage, as denoted by the debtlequity (B/S) ratio, increases.
The Net Operating Income (NOI) Approach
The net operating income approach suggests that the firmâ€™s overall cost of capital, k,, and the value
of the firmâ€™s market value of debt and stock outstanding, V, are both independent of the degree to which
the company uses leverage. The key assumption with this approach is that ko is constant regardless of
the degree of leverage.
EXAMPLE 11.6 Assume that a firm has $6,000 in debt at 5 percent interest, that the expected level of EBIT is
$2,000, and that the firmâ€™scost of capital, k,,is constant at 10percent. The market value (V) of the firm is computed
as follows:
The cost of external equity (k,)is computed as follows:
EAC = EBIT  I = $2,000  ($6,000 X 5 % )
= $2,000  $300 = $1,700
S = V B $20,000  $6,000 = $14,000
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