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1. THEORIES OF CAPITAL STRUCTURE
• The main theories of capital structure that should be familiar with are:
• Net Income Approach,
• Net Operating Income Approach (NOI), Traditional Theory, and given below

2. NET INCOME APPROACH
• Net Income Approach:
• Suggests that a company can increase its value by maximizing debt
financing as it lowers the weighted average cost of capital (WACC) due to tax
benefits on interest payments.

3. NET OPERATING INCOME APPROACH
• Net Operating Income (NOI) Approach:
• Argues that a company's capital structure doesn't affect its market value,
meaning the proportion of debt and equity is irrelevant to the firm's overall
value.

4. TRADITIONALTHEORY
• Traditional Theory:
• A middle ground between the Net Income and NOI approaches, suggesting
that there is an optimal debt level where the company can maximize value,
beyond which excessive debt can increase risk and harm value.

5. MODIGLIANI –MILLER THEORY
• Modigliani-Miller theory
• A capital structure theory that outlines the relationship between a company's
capital structure and its valuation

6. MODIGLIANI- MILLERTHEORY
• The Modigliani-Miller (MM) theorem states that a company's value is independent of
its capital structure. This means that the value of a company is not affected by the
amount of debt it has.
• What the theorem is used for
• Investors use the MM theorem to understand how a company's debt level affects its
value.
• The theorem helps estimate a company's value based on its earning power and
asset risk.

7. MMTHEOREM
The MM theorem was developed in 1958 by economists Franco Modigliani and Merton Miller.
•The original version of the theorem assumed that markets were perfectly efficient, and that
companies didn't pay taxes or experience bankruptcy costs.
•A later version of the theorem included taxes, bankruptcy costs, and asymmetric
information.

8. MMTHEORY
• The Modigliani-Miller (MM) theory is a financial theory that states that a
company's value is not affected by its capital structure. It was developed by
economists Franco Modigliani and Merton Miller in 1958.

9. MM THEORY
How it works
•The MM theory states that the value of a company is determined by its assets and earning
power, not how it finances its capital.
•The theory assumes that financial markets are perfectly efficient, there are no taxes, and there
are no bankruptcy costs.
•The MM theory has been refined to include taxes, bankruptcy costs, and asymmetric
information.

10. MMTHEORY
Applications
•The MM theory is used by investors to determine how
much debt a company can have without affecting its
value.
•The theory is one of the first formal uses of a no
arbitrage argument.

11. MMTHEORY
Criticisms
•The MM theory has been criticized for
being unrealistic, static, and not taking into
account taxes.
•There are still disputes around its validity
due to market imperfections.

12. LEVERAGE

13. LEVERAGE
•Leverage is the use of borrowed money
to increase the potential return on an
investment. It can also mean the action
of using a lever to increase force.

14. LEVERAGE
• How it works
• Leverage can be used to acquire assets, fund business operations, or
increase cash flows
• Leverage can be a very effective tool, but it also poses substantial risks
• A company with more debt than average for its industry is said to be highly
leveraged

15. LEVERAGE
Examples of leverage
•When buying real estate, a mortgage
gives you leverage to afford a more
expensive home than if you paid in cash
•A company may borrow capital through
issuing fixed-income securities or by
borrowing money directly from a lender

16. LEVERAGE
•Leverage is the amount of debt a company
has in its mix of debt and equity (its
capital structure). A company with more
debt than average for its industry is said to
be highly leveraged.

17. LEVERAGE
•Leverage is not necessarily bad. When
revenues are growing, payments are
made with comfortable surpluses and
additional debt is acquired to take
advantage of market opportunities.

18. LEVERAGE
• However, when revenues are low, a highly
leveraged business might fall behind on
debt payments and it might not be able to
borrow additional money to stay afloat.

19. LEVERAGE
• Leverage is a strategy that companies use to increase returns on
investments. There are several types of leverage, including financial,
operating, combined, and business leverage.

20. LEVERAGE
• Leverage refers to borrowing funds for a particular purpose with an
obligation to repay these funds, with interest, according to an agreed
schedule. The idea behind leverage is to help borrowers achieve a higher
return with a smaller investment.

21. LEVERAGE
• Manufacturing equipment purchase. A manufacturer borrows $1 million to
buy new, more efficient machinery. The new equipment increases production
capacity by 40% and reduces operating costs by 20%, allowing the company
to repay the loan quickly and improve long-term profitability

22. LEVERAGE
• These examples illustrate how businesses can use leverage to expand
operations, increase profits, and achieve growth that might not be possible
with only their existing capital. However, it’s crucial to carefully consider the
risks and potential returns before taking on debt

23. LEVERAGE

24. LEVERAGE

25. LEVERAGE
• Leverage refers to the use of various financial instruments or borrowed capital to
increase the potential return on investment. There are three main types of leverage:
1.Financial Leverage: This involves using debt to acquire additional assets. The
formula to calculate the degree of financial leverage (DFL) is:
• DFL=% change in EPS%
• /change in EBIT
• where EPS is earnings per share and EBIT is earnings before interest and taxes

26. OPERATING LEVERAGE
2.Operating Leverage: This type uses fixed costs in operations to amplify the
effects of changes in sales volume on profits. The formula for operating
leverage (DOL) is:
• DOL=% change in EBIT%
• / %change in sales DOL=% change in sales/% change in EBIT​

27. FINANCIAL LEVERAGE
• Financial leverage refers to the amount of debt a business has acquired.
On a balance sheet, financial leverage relates to the liabilities listed on
the right-hand side of the sheet.
• Using financial leverage allows your business to continue making
investments even if it’s short on cash. This is often preferred to equity
financing, as it allows you to raise funds without diluting your
ownership.

28. COMBINED LEVERAGE
3.Combined Leverage: This incorporates both operating and financial
leverage into the evaluation of a company's total risk. The formula for
combined leverage (DCL) is:
• DCL=DOL×DFLDCL=DOL×DFL
• It is important to carefully assess the levels of leverage as they can
significantly affect the risk

29. FINANCIAL LEVERAGE
• Financial leverage can significantly benefit businesses by:
• Amplifying returns. When investments financed by debt yield higher returns than the cost of
borrowing, the company’s overall profitability increases.
• Tax advantages. Interest payments on debt are often tax deductible, reducing the effective cost
of borrowing.
• Maintaining control. Unlike equity financing, debt doesn’t require giving up ownership or
decision-making power.
• Flexibility. Various debt instruments offer different terms and conditions to suit specific business
needs.

30. FINANCIAL LEVERAGE
• McDonald’s Corporation. The company has used leverage to fund global
expansion and franchisee support. Their debt-to-equity ratio often exceeds 100%,
yet they maintain strong credit ratings due to consistent cash flows.
• Tesla Inc. In its early years, Tesla heavily relied on debt financing to fund research,
development, and production scaling. This strategy allowed them to become a
leader in the electric vehicle market while preserving equity for early investors.
• When considering financial leverage, businesses must carefully assess their
ability to service debt and the potential return on investments funded by
borrowed capital. The optimal level of leverage varies by industry and company-
specific factors.

31. FINANCIAL LEVERAGE
• How to calculate financial leverage
• You can determine the degree of financial leverage your business has
through the debt-to-equity ratio. This ratio represents the proportion of
assets your business has compared to its shareholders’ equity.
• The formula is:

32. FINANCIAL LEVERAGE RATIO

33. OPERATING LEVERAGE
• Operating leverage
• Operating leverage accounts for the fixed operating costs and variable costs
of providing goods and services. As fixed assets don’t change with the level
of output produced, their costs are constant and must be paid regardless of
whether your business is making a profit or experiencing losses. On the
other hand, variable costs change depending on the output produced.

34. OPERATING LEVERAGE
• IT can determine operating leverage by finding the ratio of fixed costs to
variable costs. If your business has more fixed expenses than variable
expenses, it has high operating leverage. You can use a high degree of
operating leverage to magnify your returns, but too much of it can increase
your financial risk.

35. OPERATING LEVERAGE

36. COMBINED LEVRAGE
• Combined leverage
• Combined leverage accounts for your organization’s total business risks. As
the name suggests, combined leverage aggregates the effects of operating
and financial leverages to present a complete picture of your company’s
financial health.

37. COMBINED LEVERAGE
• Combined leverage accounts for your organization’s total business risks. As
the name suggests, combined leverage aggregates the effects of operating
and financial leverages to present a complete picture of your company’s
financial health.
• Capital-intensive businesses with expansion potential but insufficient levels
of cash or equity can use combined leverage. To effectively use combined
leverage though, be sure of your business’s future expenses and expected
market conditions. High levels of combined risk can make returns
susceptible to variable inputs, such as sales volumes.
• The importance of combined leverage lies in its ability to:

38. COMBINED LEVERAGE
• The importance of combined leverage lies in its ability to:
• Provide a comprehensive view of a company’s risk profile
• Help in making informed decisions about expansion or investments
• Illustrate the potential impact of changes in sales on net income
• Calculate combined leverage by multiplying the degree of operating
leverage (DOL) and the degree of financial leverage (DFL). A high combined
leverage indicates that a small change in sales can lead to a large change in
earnings per share.

39. COMBINED LEVERAGE
• Calculate combined leverage by multiplying the degree of operating
leverage (DOL) and the degree of financial leverage (DFL). A high combined
leverage indicates that a small change in sales can lead to a large change in
earnings per share.