Effective Leverage and Optimal Capital Structure
How do small firms choose their capital structure? When is it appropriate for a small business to fund its operations with borrowed funds? What is the character and function of effective leverage in financial management? These questions relate to the optimal capital structure of a business enterprise-the appropriate mix of debt and equity that maximizes the return on investment and shareholders’ wealth while minimizing the cost of capital, simultaneously. Clearly, effective leverage is vital to a sound business strategy designed to maximize the wealth producing capacity of the enterprise. In these series on effective financial management, we will focus on the pertinent financing strategic questions and provide some guidance. The overriding purpose of this article is to highlight some basic financial theory and industry practice in effective financial leverage. For specific financial management strategies please consult a competent specialized.
Please observe that the appropriate amount of financial leverage for each firm differs markedly based on the overall industry dynamics, market structure-level of competition, stage of industry life cycle, and its market competitive position. Indeed, as with most market indicators firm-specific leverage position is insightful only in reference to the industry expected value (average) and generally accepted industry benchmarks and best practices.
Types of Leverage:
Financial Leverage: Degree of financial leverage is the ratio of the EBIT/EBT-earnings before interest and taxes divided by earnings before taxes. When a business relies on borrowed funds for its operations-the financial leverage is produced as the business incurs fixed financial obligations or interests on the borrowed funds. A given percentage change in the firm’s operating income (EBIT) produces a larger percentage change in the firm’s net income (NI) and earnings per proportion. Indeed, a small percentage change in operating income (EBIT) is magnified into a larger percentage reduction in net income. The degree of financial leverage (DFL) measures a firm’s exposure to financial risk or the sensitivity of earnings per proportion (EPS) to changes in EBIT. consequently, DFL indicates the percentage change in earnings per proportion (EPS) emanating from a unit percent change in earnings before interest and taxes (EBIT). In general, a firm’s short-term financing needs are influenced by current sales growth and how effectively and efficiently the firm manages its net working capital-current assets minus current limitations. observe that current short-term financing needs may mirror a need for long-lasting long-term financing including an evaluation of the appropriate mix and use of debt and equity-the capital structure.
Operating Leverage: Fixed operating costs, such as general administrative overhead expenses, contractual employees’ salaries, and mortgage or lease payments create operating leverage and tend to elevate business risk. The impact of operating leverage is apparent when a given percentage changes in net sales results in a greater percentage change in operating income (EBIT)-earnings before interest and taxes. Operating leverage is calculated as follows: DOL = CM/EBIT-contribution margin divided by earnings before interest and taxes or percentage change in EBIT divided by percentage change in sales (revenues).
Combined Leverage: Degree of combined leverage (DCL) is the combination of the effects of business risk and financial risk. Degree of operating leverage (DOL) and degree of financial leverage (DFL) combine to magnify a given percentage change in sales to a potentially much greater percentage change in earnings or operating income (EBIT). There is a direct relationship among the degrees of operating leverage (DOL), financial leverage (DFL) and combined leverage (DCL). A firm’s degree of combined leverage (DCL) = DOL X DFL or CM/EBIT X EBIT/EBT that is CM/EBT. The degree of combined leverage (DCL) may also be calculated as percentage change in EPS divided by percentage change in sales that is the percentage change in earnings per proportion emanating from a unit percent change in sales quantity.
Optimal Capital Structure: This is the appropriate use of debt and equity that minimizes the firm’s cost of capital and maximizes its stock price. Please observe that a non-optimal capital structure or without of optimal debt and equity mix may rule to higher financing costs and the firm may reject some capital budgeting projects that would have increased shareholders’ wealth with an optimal financing. Further, the effects of different capital structures and differing degrees of business risk are reflected in a firm’s income statement. Please observe that operating leverage tends to magnify the effect of fluctuating sales (revenues) and produce a percentage change in operating income (EBIT) larger than the change in sales (revenues) while financial leverage tends to magnify the percentage change in EBIT and produce a larger percentage change in EPS. consequently, a change in sales (revenues) by operating leverage affects EBIT. This change in EBIT by the effect of financial leverage afterward affects EPS.
Some Useful Guidelines:
When a firm grows, it needs capital which may be funded by equity or debt. Debt financing has costs and benefits. Debt has two meaningful benefits: Interest paid is tax deductible, which minimizes debt’s effective cost; and debt carries a fixed charge, so stockholders do not have to proportion their net income if the enterprise is extremely profitable. however, high debt ratio indicates higher risk and hence higher cost of capital; and if the firm fails to earn sufficient income to cover its fixed charges it must produce the shortfall or confront bankruptcy. consequently, firms with volatile earnings and operating cash flows must limit their use of debt financing. Certainly, effective cash flow and leverage management is basic to prudent and sound strategy designed to maximize the wealth producing capacity of the enterprise. Additionally, strategic examination, market examination and financial examination should be internally consistent and congruent. The EBIT/EPS examination allows a firm to estimate the effects of different capital structure on operating income and the level of business risk. The tendency to change of sales or revenues over time is a basic operating risk. Please observe that in capital budgeting for a specific project to increase shareholders’ wealth, it must earn more than its cost of capital or hurdle rate.
In practice, firms tend to use target capital structure-a mix of debt, preferred stock, and shared equity with which the enterprise plans to raise needed funds. And because capital structure policy involves a strategic trade-off between risk and expected return, the optimal capital structure policy must seek a prudent and informed balance between risk and return. The firm must consider its business risk, tax position, financial flexibility and managerial conservatism or aggressiveness. While these factors are crucial in calculating the target capital structure, operating conditions may cause the actual capital structure to differ markedly from the optimal capital structure. consequently, the target capital structure should be used as a guide toward an ideal capital structure that minimizes the weighted average cost of capital (WACC) while maximizing the shareholders’ wealth.