Session 1: Introduction to Capital StructureA telecommunication regulator needs to know about capital structure and the value of the firm in order to assess if the firm is adequately financed. Capital structure gives the early warning indications on the firm’s financial distress. With a number of firms to be regulated the firm’s capital structure becomes important for continued client service. Important Learning Terms - Capital structure
- Break even analysis
- Leverage/Gearing
- MM model
- Degree of Financial Leverage
- Degree of Operation Leverage
- Degree of Combined Leverage
Introduction
The firm's session structure, the proportions of debt and equity used to finance the firm's assets, has implications for stockholder value. Additionally, capital structure affects leverage, which, in turn, affects the expected return and risk facing owners and creditors of the firm. This session analyzes the co-dependent leverage/capital structure phenomenon when the corporation has both fixed operating and fixed financial expenses in its cost structure. Capital Structure, Leverage, Leverage Effects, and the Return/Risk Relationship
Definitions: Capital structure is the mixture of sources of funds a firm uses (debt, preferred stock, common stock). The amount of debt that a firm uses to finance its assets is called leverage. A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt is said to be unlevered. Capital structure can be viewed as the permanent financing the firm represented primarily by long-term debt, preferred stock, and common equity but excluding all short term credit. Debt Vs Equity Financing
Financing a business through borrowing is cheaper than using equity. This is because: - Lenders require a lower rate of return than ordinary shareholders. Debt financial securities present a lower risk than shares for the finance providers because they have prior claims on annual income and liquidation. In addition security is often provided and covenants imposed.
- A profitable business effectively pays less for debt capital than equity for another reason: the debt interest can be offset against pre-tax profits before the calculation of the corporation tax bill, thus reducing the tax paid.
- Issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares.
There are some valuable benefits from financing a firm with debt. So why do firms tend to avoid very high gearing levels?
One reason is financial distress risk. This could be induced by the requirement to pay interest regardless of the cash flow of the business. If the firm hits a rough patch in its business activities it may have trouble paying its bondholders, bankers and other creditors their entitlement. Relationship between Expected return (Earnings per share) and the level of gearing can be represented below. 
Leverage can occur in either the operating or financing portions of the income statement The effect of leverage is to magnify the effects of changes in sales volume on earnings Leverage serves to increase both expected return and risk to the firm's stockholders 
Types of Leverage Operating leverage occurs when the firm has fixed operating expenses in its cost structure. - Operating leverage serves to magnify a given percentage change in sales into a larger percentage change in EBIT.
- Measuring Operating Leverage: The Degree of Operating Leverage (DOL)
Additional Result: Financial risk compounds the effect of business risk Combined leverage results from the interaction of both fixed operating and fixed interest expense in the firm's cost structure 
Implication: If the nature of the firm's business means its sales are inherently volatile and, because of the nature of the business, the firm must carry high fixed operating expenses, e.g., airlines, the addition of more debt to the firm's capital structure should be more carefully considered. Capital Structure Theory: Leverage and Return/Risk Considerations
A firm's capital structure is determined by the proportions of debt and equity
capital used in financing the firm's assets.
The financial manager should seek that capital structure which maximizes
the value of the firm (the optimal capital structure).
The capital structure decision and the firm's leverage position are co-determined. Determinants of the Firm's Optimal Capital Structure - The Tax Deductibility of Interest
The tax deductibility feature of interest expense tends to increase the use of debt in the firm's capital structure. - Financial Risk
The increased financial risk that comes with increased use of debt tends to moderate the use of debt in the firm's capital structure.
Result: The firm's optimal capital structure should represent a balance between debt and equity. Such cost advantage that comes from using cheaper debt is just matched by the increase in the increase in financial risk that comes with more debt. Determination of the Firm's Capital Structure in the Real World - It is difficult (or impossible) for the financial manager to exactly determine the firm's optimal capital structure.
- The financial manager needs to consider demand sustainability and volatility as well as cost stability when making the debt/equity choice.
- There probably exists a range of acceptable (optimal) debt/asset ratios.
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