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.