Lessons

- CFA Level 2: Corporate Finance Part 1 – Introduction
- Introduction to Capital Structure and Leverage
- Introductory Capital Budgeting Remarks
- Expansion Projects vs. Replacement Projects and Cash Flows
- Impacts of Depreciation Method Choice on Capital Budget Analysis
- Inflation and Capital Budgeting
- Mutually Exclusive Capital Projects with Unequal Lives
- Equivalent Annual Annuity (EAA) Approach
- Least Common Multiple of Lives Approach
- Stand Alone Risk and Capital Projects
- CAPM and a Capital Project’s Discount Rate
- Capital Projects and Real Options
- Common Pitfalls in Capital Budgeting
- Capital Budgeting Alternatives to NPV and IRR Analysis
- Modigliani-Miller and Capital Structure Theory
- Evaluating Capital Structure Policy
- International Differences in Financial Leverage
- Dividend and Share Repurchase Policies
- Factors Affecting Corporate Dividend Policy Decisions
- Signals from Dividend Policies

# Introduction to Capital Structure and Leverage

**Capital Structure**

- A firm’s capital structure represents its mix of capital sources, i.e. its mix of debt financing and equity financing.
- In theory, companies should seek an optimal capital structure with the objective of minimizing the cost of capital.
- The cost of capital is typically its weighted average cost of capital (WACC), applying the marginal cost of debt financing and equity financing. Since interest is typically a tax deductible expense, the WACC calculation will incorporate the after tax cost of debt.

**Leverage**

- Leverage is the utilization of fixed costs by a company.
- Leverage can be operating (fixed assets that depreciate) or financial (debt).
- While financial leverage and operating leverage can amplify earnings during periods of growth, they can also increase the risk of financial distress during periods of economic decline.
- Financial leverage exposes a company to financial risk.
- The degree of financial leverage (DFL) can be calculated as:

DFL = EBIT/EBTWhen a firm has no debt, EBIT = EBT, so DFL will = 1. Upon assuming debt, a firm’s DFL will increase above 1.

- Another method of considering financial leverage is a company’s debt to equity ratio.

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