Capital Structure Interview Preparation Guide

Modigilani-Miller approach is also known as MM approach which looks similar to Net operating income approach. It is in synchronization with the Net operating income approach and states in acceptance with the approach that cost of capital is independent of degree of leverage. It provides justification for operational and behavioural for constant cost of capital at any degree of leverage as this is not being provided by the Net operating Income approach. It is been assumed in this approach that capital markets are perfect and the investors are investing in the company from the same expectation of the company's net operating income in search of evaluating the value of the firm. The propositions of this approach can be mentioned in the following ways and it is as follows:-

1) Company's overall cost of capital and value of the firm is constant at any degree of leverage as it is independent of the capital structure.

2) Capital investment which has the minimum cut-off rate is also independent of project finances.

If this approach has advantages then it has certain limitations associated with it and the limitations are as follows:-

1) Investors find the leverages inconvenient and risk perception of corporate and personal leverage is different.

2) Corporate doesn't exist but it gets removed later.

3) Arbitrary process doesn't have any restrictions and it is also not be affected by transaction cost.

Financial leverage is the leverage in which a company decides to finance majority of its assets by taking on debt. The leverages have been applied by investors and companies to generate more returns on their assets. This employment of leverage doesn't guarantee success and increases the possibility of excessive losses which becomes more great in high leverage positions. Firms use this leverage when they are unable to raise enough capital by issuing shares in the market and unable to meet their business needs. When firm takes on debt it sees that at that time how is the return on assets and for a firm it should be higher than the interest on the loan.

How is it calculated?

The calculation of financial leverage takes place in following steps:-
1) Calculation of total debt is carried out by the company which includes short term debt as well as long term debt.

2) Calculation of total equity takes place in the company by shareholders to find out the equity they multiply number of outstanding shares by stock price. This amount is represented as shareholder equity.

3) To calculate financial leverage ratio divide total debt with total equity.

4) If company has high financial leverage ratio than it could be a sign of financial weakness. This can also lead to bankruptcy if the company is highly leveraged.

High financial leverage indicates the risky investment made by the company's shareholders. Low financial leverage indicates that management has adopted a very good approach towards the debt capital. This decreases the management decision making on earning per share.

Financial leverage indicates borrow of funds to raise the capital by issuing shares in the market to meet their business requirements. This also indicates the profitability and return on equity of the company which has taken significant amounts of debt. The financial leverage has many advantages but it possess some limitations as well which has been shown as follows:-

1) When a company borrows funds using financial leverage then this money develops an environment that can either creates lots of profits or a small amount of it.

2) Borrowing constantly creates an image that the company might be on high risk. Which in turn increases the interest rates and some restrictions could be handed over to the borrowing organization.

3) Value of stock also gets affected as it can drop substantially if the stockholders intervene in between.

High operating leverage and high financial leverage indicates the risky investment made by the company's shareholders. This also indicates that company is making few sales but with high margins. This shows the risk if a firm incorrectly forecasts future sales. If the future sales have been manipulative forecasted then it create a difference between actual and budgeted cash flow, which affects the company's future operating ability. The financial leverage poses high risk when a company's return on assets doesn't exceed interest on loan, which lowers down company's return on equity and profitability.

High operating leverage indicates that company is making few sales but with high margins. This shows the risk if a firm incorrectly forecasts future sales. If the future sales have been manipulative forecasted then it create a difference between actual and budgeted cash flow, which affects the company's future operating ability. Low financial leverage indicates that management has adopted a very good approach towards the debt capital. This decreases the management decision making on earning per share. This is the optimum situation.

If financial leverage is high than the funds are obtained mainly through preference shares, debentures and debts. This makes the base solid by keeping the operating leverage low on scale. The financial decision can be maximized as the management's concern can be earning per share which will favour the debt capital only. This will increase when the rate of interest on debentures is lower than rate of return in business. The decision is based on earning per share without any indication of the risks involved.

This is also a worst situation where both operating leverage and financial leverage are low which results in undesirable consequences. Low degree of these leverages shows that the amount of fixed costs is very small and proportion of debts in capital is also low. The management in this situation might loose number of profitable opportunities and investments.

Traditional approach is also known as Net income approach but it is the simplest form. It is in between the other two theories named as Net income theory and Net operating income theory. This approach has been formulated by Ezta Solomon and Fred Weston. This theory gives the right and correct combination of debt and equity shares and always lead to enhanced market value of the firm. This approach tells about the financial risk which will be undertaken by the equity shareholders. This approach focuses mainly on increasing the cost of equity capital which will be done after a level of debt in the capital structure

Operating income approach is the approach which suggests the decision of capital structure towards a firm is irrelevant and change in leverage or debt doesn't result in change of total and market price of the firm. It tells that overall cost of capital is independent of degree of leverage. This approach was also proposed by David Durand.