Financing Decisions - Capital Structure and Leverage
Capital structure and leverage examine how fixed financing charges magnify the effect of operating results on EPS and shareholder risk. The exam tests DOL, DFL, combined leverage and EBIT–EPS indifference.
Core rules
- DOL = contribution/EBIT = % change in EBIT/% change in sales.
- DFL = EBIT/(EBIT − interest − preference dividend/(1 − tax)).
- DCL = DOL × DFL = contribution/(EBIT − interest − preference dividend/(1 − tax)).
- MM without taxes says capital structure is irrelevant; with taxes, debt adds a tax shield; trade-off theory balances tax benefits against financial distress costs.
- Pecking order prefers internal funds, then debt, then equity.
Worked example
Contribution is ₹300 lakh, fixed operating costs ₹100 lakh, EBIT ₹200 lakh, interest ₹50 lakh and tax 25%, with no preference dividend. DOL = 300/200 = 1.50. DFL = 200/(200−50) = 1.33. DCL = 1.50×1.33 = 2.00. A 10% rise in sales raises EBIT by 15% and EPS by 20%. If interest rose to ₹80 lakh, DFL would become 200/120 = 1.67, increasing shareholder risk even though operating leverage is unchanged.
Traps
Do not use PAT in DFL; add preference dividend grossed up for tax; DOL is undefined or explosive near zero EBIT; high DCL is not automatically bad if cash flows are stable; and EPS maximisation is not the same as value maximisation because it ignores risk.