Capital Structure Theory
Capital Structure Theory
Capital Structure Theory
CAPITAL
STRUCTURE
THEORY
Chapter
CAPITAL STRUCTURE AND LEVERAGE
Financial Leverage
financial leverage is the ability of the firm to use fixed financial charges to
magnify the effects of changes in EBIT on the firms earnings per share.
In other words, financial leverage may be defined as the payment of fixed rate
of interest for the use of fixed interest bearing securities to magnify the rate of
return as equity shares
assumptions that the fixed-charges funds (such as the loan from financial
institutions and banks or debentures) can be obtained at a cost lower than the
financial leveraged
structure.
In the absence of taxes, an
ko
individual holding all the debt and
kd
equity securities will receive the
same cash flows regardless of the
Debt
capital structure and therefore,
value of the company is the
same.
Copyright 2008, Dr Sudhindra Bhat
MMs Proposition II
The cost of equity for a levered firm equals the constant overall cost of capital
plus a risk premium that equals the spread between the overall cost of capital
and the cost of debt multiplied by the firms debt-equity ratio. For financial
leverage to be irrelevant, the overall cost of capital must remain constant,
regardless of the amount of debt employed. This implies that the cost of equity
must rise as financial risk increases.