Capital Structure: Capital Structure is the mix of financial securities used to finance the firm. The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V = B + S If the goal of the management of the firm is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.

1. Debt versus Equity
04/30/18
Developed by Dr IKRAM UL HAQ CHOUDHARY PhD
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2. 2
 Definition: Capital Structure is the mix of financial
securities used to finance the firm.
 The value of a firm is defined to be the sum of the value of the
firm’s debt and the firm’s equity.
 V = B + S
 If the goal of the management of the firm is to make the firm
as valuable as possible, then the firm should pick the debt-
equity ratio that makes the pie as big as possible.
Value of the FirmBS
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD

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 Leverage is the use of various financial
instruments or borrowed capital, such as
margin, to increase the potential return of an
investment.
 2. The amount of debt used to finance a firm's assets. A
firm with significantly more debt than equity is considered
to be highly leveraged.
 Leverage is most commonly used in real estate
transactions through the use of mortgages to purchase a
home.
 Leveraging enables gains and losses to be multiplied. On
the other hand, there is a risk that leveraging will result in
a loss — ie., it actually turns out that financing costs
exceed the income from the asset, or because the value
of the asset has fallen. 04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD

4. 4
 In finance, leverage (sometimes referred to as gearing in the
United Kingdom and Australia) is any technique involving the
use of borrowed funds in the purchase of an asset, with the
expectation that the after tax income from the asset and asset
price appreciation will exceed the borrowing cost. Normally,
the finance provider would set a limit on how much risk it is
prepared to take and will set a limit on how much leverage it
will permit, and would require the acquired asset to be
provided as collateral security for the loan. For example, for a
residential property the finance provider may lend up to, say,
80% of the property's market value, for a commercial property
it may be 70%, while on shares it may lend up to, say, 60% or
none at all on some shares.
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD

5.  Business Risk
 Company Tax exposure
 Financial Flexibility
 Management Style
 Growth Rate
 Market Condition
 Cost of Fixed Assets
 Size of Business Organization
 Nature of business Organization
 Elasticity of Capital Structure
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 5

6.  Net Income Approach (NI)
 Net Operating Income Approach (NOI)
 Traditional Approach (TA)
 Modigliani and Miller Approach (MM)
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 6

7.  Need to consider two kinds of risk:
◦ Business risk
◦ Financial risk
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 7

8.  Standard measure is beta (controlling for financial
risk)
 Factors:
◦ Demand variability
◦ Sales price variability
◦ Input cost variability
◦ Ability to develop new products
◦ Foreign exchange exposure
◦ Operating leverage (fixed vs variable costs)
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 8

9.  The additional risk placed on the common
stockholders as a result of the decision to finance
with debt
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 9

10.  If the same firm is now capitalized with 50% debt
and 50% equity – with five people investing in debt
and five investing in equity
 The 5 who put up the equity will have to bear all
the business risk, so the common stock will be
twice as risky as it would have been had the firm
been all-equity (unlevered).
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 10

11.  Financial leverage concentrates the firm’s
business risk on the shareholders because debt-
holders, who receive fixed interest payments, bear
none of the business risk.
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 11

12.  Leverage increases shareholder risk
 Leverage also increases the return on equity (to
compensate for the higher risk)
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 12

13.  Interest is tax deductible (lowers the effective cost
of debt)
 Debt-holders are limited to a fixed return – so
stockholders do not have to share profits if the
business does exceptionally well
 Debt holders do not have voting rights
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 13

14.  Higher debt ratios lead to greater risk and higher
required interest rates (to compensate for the
additional risk)
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 14

15. Thank you
04/30/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY PhD 15