Chapter 5: Capital Structure and Leverage
Capital structure is the mix of debt and equity a firm uses to finance its operations. Leverage refers to the use of fixed-cost sources (debt) to amplify returns. The optimal capital structure minimizes WACC and maximizes firm value. This chapter covers leverage analysis, capital structure theories, and EBIT-EPS analysis.
5.1 Types of Leverage
| Type | Fixed Cost | Measures | Formula |
|---|---|---|---|
| Operating Leverage (DOL) | Fixed operating costs (rent, depreciation) | Sensitivity of EBIT to changes in sales | DOL = % change in EBIT / % change in Sales = Contribution / EBIT |
| Financial Leverage (DFL) | Fixed financial costs (interest) | Sensitivity of EPS to changes in EBIT | DFL = % change in EPS / % change in EBIT = EBIT / (EBIT - Interest) |
| Combined/Total (DCL) | Both operating and financial | Sensitivity of EPS to changes in sales | DCL = DOL × DFL = Contribution / (EBIT - Interest) |
Leverage Example
Data: Sales = NPR 10,00,000, Variable cost = 60%, Fixed operating cost = NPR 2,00,000, Interest = NPR 50,000
Contribution = 10,00,000 × 40% = 4,00,000
EBIT = 4,00,000 - 2,00,000 = 2,00,000
EBT = 2,00,000 - 50,000 = 1,50,000
DOL = 4,00,000 / 2,00,000 = 2.0 (10% sales increase → 20% EBIT increase)
DFL = 2,00,000 / 1,50,000 = 1.33 (10% EBIT increase → 13.3% EPS increase)
DCL = 2.0 × 1.33 = 2.67 (10% sales increase → 26.7% EPS increase)
5.2 Capital Structure Theories
| Theory | Key Proposition | Optimal Structure |
|---|---|---|
| Net Income (NI) | More debt always reduces WACC and increases value | 100% debt (unrealistic) |
| Net Operating Income (NOI) | Capital structure is irrelevant; WACC is constant | No optimal structure |
| Modigliani-Miller (No Tax) | In perfect markets, capital structure is irrelevant to value | No optimal structure |
| MM (With Tax) | Debt creates tax shield; value increases with debt | 100% debt (but ignores bankruptcy costs) |
| Traditional/Trade-off | Optimal mix balances tax benefit of debt against bankruptcy costs | Moderate debt level where WACC is minimized |
| Pecking Order | Firms prefer internal funds first, then debt, then equity last | No fixed optimal; depends on information asymmetry |
5.3 EBIT-EPS Analysis
Compares the impact of different financing alternatives on EPS at various EBIT levels. The indifference point is where both plans give the same EPS.
Example: Firm needs NPR 10L. Plan A: All equity (10,000 new shares at NPR 100). Plan B: NPR 5L debt at 12% + 5,000 shares. Existing shares: 20,000. Tax = 25%.
Indifference EBIT:
(EBIT - 0)(1-0.25)/30,000 = (EBIT - 60,000)(1-0.25)/25,000
0.75 × EBIT / 30,000 = 0.75 × (EBIT - 60,000) / 25,000
25,000 × EBIT = 30,000 × (EBIT - 60,000)
25,000 EBIT = 30,000 EBIT - 18,00,000
5,000 EBIT = 18,00,000
Indifference EBIT = NPR 3,60,000
Above this EBIT: Plan B (debt) gives higher EPS. Below: Plan A (equity) is better.
5.4 EBIT-EPS Analysis — Comprehensive Three-Plan Example
A Nepali company needs NPR 50,00,000. Current shares = 50,000. Three financing plans:
| Plan | Equity (shares) | 12% Debt | 10% Preference |
|---|---|---|---|
| Plan A (All Equity) | 50,000 new shares | — | — |
| Plan B (Debt + Equity) | 25,000 new shares | NPR 25,00,000 | — |
| Plan C (Mix of all) | 10,000 new shares | NPR 25,00,000 | NPR 15,00,000 |
Tax rate = 30%
EPS Calculation at EBIT = NPR 10,00,000:
| Item | Plan A | Plan B | Plan C |
|---|---|---|---|
| EBIT | 10,00,000 | 10,00,000 | 10,00,000 |
| Less: Interest | 0 | 3,00,000 | 3,00,000 |
| EBT | 10,00,000 | 7,00,000 | 7,00,000 |
| Less: Tax (30%) | 3,00,000 | 2,10,000 | 2,10,000 |
| EAT | 7,00,000 | 4,90,000 | 4,90,000 |
| Less: Pref Dividend | 0 | 0 | 1,50,000 |
| Earnings for equity | 7,00,000 | 4,90,000 | 3,40,000 |
| Total equity shares | 1,00,000 | 75,000 | 60,000 |
| EPS | NPR 7.00 | NPR 6.53 | NPR 5.67 |
At EBIT = 10L, Plan A gives highest EPS. But at higher EBIT levels, Plan B and C become better due to financial leverage.
Indifference EBIT (Plan A vs Plan B):
(EBIT)(1-0.30) / 1,00,000 = (EBIT - 3,00,000)(1-0.30) / 75,000
75,000 × EBIT = 1,00,000 × (EBIT - 3,00,000)
75,000 EBIT = 1,00,000 EBIT - 30,00,00,000
25,000 EBIT = 30,00,00,000
Indifference EBIT = NPR 12,00,000
At EBIT > 12L: Plan B gives higher EPS (leverage advantage). At EBIT < 12L: Plan A is better (no interest burden).
5.5 Financial Leverage Effect on ROE
Firm A (No debt): Total assets = NPR 100L, all equity. EBIT = 15L. Tax = 25%.
ROE = 15(1-0.25)/100 = 11.25/100 = 11.25%
Firm B (50% debt at 10%): Assets = 100L, Equity = 50L, Debt = 50L. EBIT = 15L.
Interest = 50 × 10% = 5L. EBT = 10L. Tax = 2.5L. EAT = 7.5L.
ROE = 7.5/50 = 15% (higher due to leverage!)
But if EBIT drops to 5L:
Firm A ROE = 5(0.75)/100 = 3.75%
Firm B: Interest = 5L. EBT = 0. ROE = 0% (all profit goes to interest)
If EBIT = 3L:
Firm A ROE = 3(0.75)/100 = 2.25%
Firm B: Interest = 5L > EBIT 3L → LOSS! ROE = negative
Lesson: Leverage amplifies returns in both directions. When EBIT > cost of debt, leverage boosts ROE. When EBIT < cost of debt, leverage destroys equity value. This is why Nepal's NRB sets strict capital adequacy for banks — to limit dangerous leverage.
5.6 Optimal Capital Structure — Trade-off Theory in Practice
| Debt Ratio | Cost of Debt (Kd) | Cost of Equity (Ke) | WACC | Firm Value |
|---|---|---|---|---|
| 0% | — | 14% | 14.0% | NPR 100L |
| 20% | 8% | 15% | 13.6% | NPR 103L |
| 40% | 9% | 16% | 13.2% | NPR 106L |
| 50% | 10% | 17% | 13.0% | NPR 108L (Optimal) |
| 60% | 12% | 19% | 13.4% | NPR 104L |
| 80% | 16% | 24% | 17.6% | NPR 80L |
Optimal at 50% debt: WACC is minimized (13.0%) and firm value is maximized (NPR 108L). Beyond 50%, bankruptcy risk increases Kd and Ke sharply, overwhelming the tax benefit of debt. This illustrates the trade-off theory — the optimal point balances tax shield benefit against financial distress cost.
5.7 Capital Structure in Nepal — Industry Patterns
| Industry | Typical D/E Ratio | Reason |
|---|---|---|
| Commercial Banks | 8:1 to 10:1 | Deposits are "debt"; NRB capital adequacy ~11% equity minimum |
| Manufacturing | 1:1 to 2:1 | Moderate leverage; asset-backed borrowing |
| IT/Services | 0.2:1 to 0.5:1 | Low fixed assets; rely on equity and retained earnings |
| Hydropower | 2:1 to 3:1 | High capital needs; project financing with debt |
| Hotels/Tourism | 1:1 to 1.5:1 | Property-backed debt; seasonal cash flows limit heavy leverage |
Practice Questions
Short Answer:
1. Define operating, financial, and combined leverage.
2. What is the trade-off theory of capital structure?
3. State the MM proposition (with and without taxes).
4. What is EBIT-EPS indifference point?
5. Explain the pecking order theory.
Long Answer:
6. Sales NPR 20L, VC ratio 50%, Fixed costs NPR 5L, Interest NPR 2L. Calculate DOL, DFL, DCL. If sales increase 15%, what is % change in EPS? (15 marks)
7. Compare NI, NOI, and MM theories of capital structure. Which is most realistic? (15 marks)
8. Two financing plans: Plan A (all equity 50,000 shares), Plan B (NPR 20L debt @10%, 30,000 shares). Tax 30%. Find indifference EBIT and EPS. Advise if expected EBIT is NPR 8L. (15 marks)
9. Discuss the optimal capital structure. How should a Nepali company determine its debt-equity mix? (15 marks)
10. "High leverage magnifies both gains and losses." Discuss risks and benefits of financial leverage for NEPSE-listed companies. (15 marks)
Exam Tips: ✓ Leverage calculations (DOL, DFL, DCL) always asked ✓ EBIT-EPS indifference point is a common numerical ✓ Know all capital structure theories for comparison ✓ Trade-off theory is most practical ✓ Show clear working for all calculations