Capital Structure and Long-Term Financing

Introduction

Capital structure is the mix of long-term debt, preferred equity, common equity, and related financing instruments used by a firm. Long-term financing determines not only how assets are funded, but also how risk, control, cash-flow claims, taxation, and returns are distributed among investors. A financing decision therefore extends beyond choosing the least expensive source of funds. It requires an assessment of business risk, financial flexibility, market conditions, governance, information asymmetry, and the probability and cost of financial distress.

A firm with substantial fixed operating costs may already face high operating risk. Adding fixed financial obligations such as interest and principal repayments can magnify the variability of earnings available to ordinary shareholders. Conversely, carefully selected debt may create tax benefits, discipline managerial behavior, and reduce the cost of capital. The central managerial problem is to identify a financing mix that supports strategy while preserving solvency and stakeholder confidence.

This chapter examines operating and financial leverage, EBIT–EPS analysis, major capital-structure theories, financial distress, and the principal forms of long-term finance. It also compares public, private, hybrid, and venture financing and considers governance, regulation, ethics, and contemporary practice.

Learning Objectives

By the end of this chapter, you should be able to:

1. Explain operating leverage, financial leverage, and their combined effect on shareholder risk.
2. Calculate and interpret break-even sales, degree of operating leverage, degree of financial leverage, and degree of combined leverage.
3. Apply EBIT–EPS analysis to compare alternative financing plans.
4. Explain the Modigliani–Miller, trade-off, pecking-order, signaling, and agency theories.
5. Evaluate financial distress and the benefits and costs of debt.
6. Compare bonds, term loans, equity, preferred shares, convertibles, private equity, and venture capital.
7. Recommend a financing structure using financial, strategic, ethical, and governance criteria.

1. Operating and Financial Leverage

Operating leverage

Operating leverage arises from fixed operating costs. Rent, salaried production supervision, depreciation, and some technology costs do not change directly with short-run sales volume. Once fixed costs are covered, an additional unit of contribution makes a relatively large contribution to operating profit. The same structure causes operating profit to fall rapidly when sales decline.

Let:

• S = sales revenue;
• V = total variable operating cost;
• F = fixed operating cost, excluding interest and taxes;
• Q = units sold;
• P = selling price per unit; and
• v = variable cost per unit.

Contribution margin is sales less variable cost:

Operating income, or EBIT, is:

The accounting break-even quantity is the sales volume at which EBIT equals zero:

This formula assumes constant unit price and variable cost, and separates fixed from variable operating costs. It is a planning relationship, not a complete financial viability test: it ignores taxes, financing costs, capacity limits, changing prices, and cash-flow timing.

The degree of operating leverage at a particular sales volume is:

Equivalently, when the underlying linear assumptions hold:

DOL is a dimensionless sensitivity measure. A DOL of 2 means that a 1% change in sales is associated approximately with a 2% change in EBIT, provided price, unit variable cost, and fixed cost remain constant and the firm is not near a discontinuity such as a capacity constraint.

Financial leverage

Financial leverage results from fixed financial charges, especially interest and preferred dividends. It magnifies changes in earnings available to common shareholders. If debt is used successfully, shareholders may earn a higher return; if operating income falls, interest still has to be paid and shareholder earnings may decline sharply.

For a firm with interest expense I, preferred dividend PD, and corporate tax rate T, earnings available to common shareholders are:

This expression assumes interest is deductible for tax purposes and that preferred dividends are stated after tax. If preferred dividends are issued, they are not normally tax-deductible.

A common definition of the degree of financial leverage at a given EBIT is:

When there is no preferred stock, this reduces to:

DFL approximates the percentage change in earnings available to common shareholders resulting from a 1% change in EBIT. It is meaningful only at an EBIT level where the denominator is positive and the financing assumptions remain unchanged.

Combined leverage

Operating and financial leverage interact. The degree of combined leverage is:

Under the no-preferred-stock case, it can also be expressed as:

A high DCL means that a small change in sales may produce a much larger change in common shareholders’ earnings. Leverage is therefore not inherently good or bad. It is a risk-return mechanism whose suitability depends on the stability of cash flows and the firm’s capacity to withstand adverse outcomes.

Worked example: leverage

Illustrative Company sells 10,000 units at £50 each. Variable cost is £30 per unit, fixed operating cost is £120,000, and annual interest is £20,000. There is no preferred stock and the tax rate is 25%.

Sales equal £500,000 and variable cost equals £300,000. Thus contribution margin is £200,000 and:

The measures are:

Approximately, a 1% change in sales produces a 3.33% change in earnings available to ordinary shareholders, assuming all other conditions remain constant. The after-tax earnings to common are (£80,000 − £20,000) × 0.75 = £45,000.

2. EBIT–EPS Analysis

EBIT–EPS analysis compares the earnings per share produced by alternative financing plans at different operating-income levels. It is useful when management is deciding whether a project should be financed with debt, ordinary shares, or a combination.

For a plan with interest I, preferred dividend PD, tax rate T, and number of ordinary shares N, earnings per share are:

The equation assumes that the number of shares, interest, tax rate, and preferred dividend are known for the relevant period. It does not by itself measure market value, risk, probability of distress, or the quality of earnings.

The EBIT indifference point is the EBIT level at which two financing plans produce the same EPS. For plans A and B:

If both plans have the same tax rate, the tax factor may be cancelled during algebraic solution. The comparison becomes less reliable when plans have different tax treatments, complex convertibles, changing share counts, or materially different default probabilities.

Worked example: debt versus equity

A company needs £1,000,000. Plan D uses debt at 8%, creating annual interest of £80,000, and leaves 100,000 shares outstanding. Plan E issues 50,000 new shares at £20 each, resulting in 150,000 shares and no new interest. Assume a 25% tax rate and EBIT of £300,000.

Under Plan D:

Under Plan E:

At this EBIT, debt financing produces the higher EPS. The indifference EBIT is found by equating the plans:

Cancelling 0.75 and solving gives:

Above £240,000, the debt plan produces higher EPS; below £240,000, the equity plan produces higher EPS. However, debt also increases default risk. A responsible decision would compare the expected EPS benefit with cash-flow volatility, covenant restrictions, credit ratings, refinancing risk, and the value of financial flexibility.

3. Capital-Structure Theories

Modigliani–Miller propositions

Modigliani and Miller provided the benchmark for analyzing capital structure. In their simplest proposition, under perfect capital-market assumptions, capital structure does not affect total firm value. The assumptions include no taxes, no transaction costs, no bankruptcy costs, symmetric information, rational investors, and the ability of investors and firms to borrow at equivalent rates.

Under these restrictive assumptions:

where V_L is the value of the levered firm and V_U is the value of the otherwise identical unlevered firm. Leverage changes the distribution of risk and return, but not total value.

The cost of equity rises with leverage because common shareholders bear greater financial risk. In the no-tax version:

where k_e is the cost of equity, k₀ is the unlevered cost of equity, k_d is the pre-tax cost of debt, D is market debt, and E is market equity. This relationship assumes constant borrowing rates and the idealized conditions of the model.

When corporate tax is introduced, interest creates a tax shield. In the basic perpetual-debt version:

where T_C is the corporate tax rate and D is the market value of permanent debt. The tax shield’s value is T_C D under assumptions of tax-paying profits, deductible interest, and sufficiently permanent debt. Real firms may not obtain the full benefit because of losses, interest-limitation rules, changing debt, or tax-rate uncertainty.

The weighted average cost of capital is commonly written as:

This formula uses market-value weights and applies to projects with risk comparable to the existing business and to financing proportions maintained over time. It should not be used mechanically for projects with substantially different business risk.

Trade-off theory

Trade-off theory recognizes that debt provides benefits but also creates expected costs. The firm balances the marginal tax benefit of additional debt against the marginal expected costs of financial distress and related agency problems.

Conceptually:

Expected distress cost is not limited to formal bankruptcy. It includes legal and administrative costs, lost customers and suppliers, employee departures, underinvestment, restricted investment decisions, and management time diverted to restructuring. The optimal debt level is where the incremental value of the tax shield equals the incremental expected cost of distress.

Trade-off reasoning predicts that firms with stable tangible assets and taxable profits can generally sustain more debt than firms with volatile earnings, intangible assets, or strong growth options. It also predicts that tax rules, interest rates, collateral values, and industry norms influence leverage.

Pecking-order theory

Pecking-order theory emphasizes information asymmetry between managers and outside investors. Managers typically know more about the firm’s prospects than external financiers. Issuing securities can therefore convey information and impose issuance costs.

A typical financing hierarchy is:

1. internally generated funds;
2. relatively safe debt;
3. riskier debt or hybrid securities; and
4. new ordinary equity as a last resort.

The theory does not claim that every firm follows this order rigidly. It predicts that firms may retain cash in good years and use it in poor years, and that equity issues may occur when debt capacity is limited or when managers believe equity is fairly valued. Unlike trade-off theory, pecking-order theory does not necessarily predict a single target debt ratio.

Signaling theory

Financing choices may communicate information. A debt issue can signal managerial confidence if managers believe future cash flows will comfortably service the obligation. An equity issue may be interpreted negatively if investors suspect that management believes the shares are overvalued. These interpretations are not universal: equity may be issued for growth, diversification, regulatory capital, or balance-sheet repair.

A signal is credible only when it is costly to imitate. Excessive borrowing may not be a credible positive signal if it simply reflects aggressive risk-taking. Investors therefore examine the financing choice together with use of proceeds, covenants, forecasts, ownership changes, and subsequent performance.

Agency theory

Agency conflicts arise because managers, shareholders, and lenders may have different objectives. Debt can reduce free cash flow available for managerial overinvestment and can impose monitoring through covenants. However, high leverage may encourage shareholders to pursue excessively risky projects because shareholders receive much of the upside while lenders bear part of the downside. This is the asset-substitution problem.

Debt can also cause underinvestment. If much of a new project’s value would accrue to existing lenders, shareholders may reject a positive-net-present-value project. Managers may additionally avoid valuable projects to preserve private benefits or employment. Covenants, collateral, monitoring, convertible claims, managerial ownership, and board oversight are mechanisms for reducing these conflicts.

4. Financial Distress and the Limits of Debt

Financial distress occurs when a firm experiences difficulty meeting contractual financial commitments. It may begin with liquidity pressure, covenant violations, or missed payments and may culminate in formal insolvency or restructuring. Insolvency can mean either inability to pay debts as they fall due or liabilities exceeding asset value, depending on the legal system.

The probability of distress rises with volatile operating cash flows, high fixed costs, short debt maturities, foreign-currency obligations without matching revenues, floating interest rates, weak liquidity, and dependence on refinancing. Distress costs can be direct or indirect:

• direct legal, advisory, court, and administrative expenses;
• lost sales because customers fear interruption or poor after-sales service;
• supplier demands for cash payment;
• employee departures and recruitment difficulty;
• asset sales at distressed prices;
• restricted investment and research expenditure; and
• reputational damage.

Liquidity analysis should complement leverage ratios. Important indicators include interest coverage, debt-service coverage, maturity concentration, free cash flow, unused committed credit lines, and sensitivity to interest-rate or exchange-rate changes. Interest coverage is often expressed as:

This ratio is simple but incomplete. It ignores principal repayments, taxes, capital expenditure, working-capital needs, and cash balances. A firm with apparently strong EBIT coverage may still face a liquidity crisis if debt maturities are concentrated or cash conversion is weak.

5. Sources of Long-Term Finance

Long-term bank loans and term finance

Term loans provide contractual funds for a specified maturity, often with scheduled amortization or a final bullet repayment. Interest may be fixed or floating. Loan agreements commonly contain representations, information requirements, financial covenants, negative pledges, restrictions on asset sales, and limits on additional borrowing.

Advantages include speed, negotiated flexibility, confidentiality, and suitability for firms that do not access public markets. Disadvantages include collateral requirements, covenants, refinancing risk, floating-rate exposure, and possible dependence on one or a small number of lenders.

Bonds and debentures

A bond is a tradable debt instrument in which the issuer promises interest and repayment of principal according to contractual terms. A bond may be secured by specified assets or unsecured. Key features include maturity, coupon, yield, call provisions, put provisions, sinking funds, covenants, seniority, currency, and ranking in insolvency.

The bond’s coupon rate is not the same as its required return. When market yields rise above the coupon rate, the bond’s price generally falls; when yields fall, its price generally rises. Public issuance can provide substantial funds and diversify lenders, but it requires disclosure, ratings or investor analysis, underwriting, listing or regulatory compliance, and continuing reporting.

Ordinary equity

Ordinary shares have no mandatory repayment date and normally carry voting rights and a residual claim on profits and assets. Equity strengthens the balance sheet and absorbs losses, but it dilutes existing ownership and may be expensive because shareholders require compensation for residual risk. Dividends are generally discretionary and are not tax-deductible.

Equity is particularly valuable when cash flows are uncertain, assets are intangible, or preserving debt capacity is strategically important. Issuance decisions must consider valuation, control, market timing, disclosure, and the rights of existing shareholders.

Preferred shares

Preferred shares usually provide a stated dividend priority over ordinary shares and a priority claim over ordinary equity in liquidation, but they rank below debt. They may be cumulative, non-cumulative, redeemable, convertible, or participating. Preferred dividends generally do not create the same tax deduction as interest. Preferred equity can reduce immediate voting dilution but may create a fixed or expected distribution burden.

Hybrid securities

Hybrids combine debt-like and equity-like characteristics. Convertible bonds pay contractual interest but allow conversion into ordinary shares under specified conditions. Warrants provide a right to buy shares at a stated exercise price. Contingent convertible instruments may convert or absorb losses when a financial trigger is reached. Mezzanine finance may combine subordinated debt, warrants, and equity features.

Hybrids can reduce the immediate cost of financing or postpone dilution, but valuation is complex. The issuer must assess conversion thresholds, dilution, ranking, embedded options, accounting classification, investor protections, and regulatory treatment. A hybrid is not automatically less risky than either plain debt or equity.

Private equity and private placements

Private placements sell securities to a limited group of institutional or sophisticated investors rather than through a broad public offering. They may be faster and more confidential, but securities can be less liquid and investors may require stronger covenants, board representation, or negotiated exit rights.

Private equity investors commonly provide capital to mature or growing businesses in exchange for an ownership stake and governance rights. They may support acquisitions, operational change, succession, or recapitalization. Their investment horizon, return expectations, exit route, and influence over management should be clearly understood.

Venture capital

Venture capital finances young firms with high growth potential but substantial technological, market, and execution risk. Funding is commonly staged through multiple rounds. Staging allows investors to release capital when milestones are achieved and to abandon projects that fail to demonstrate progress. Venture investors may provide expertise, recruitment, contacts, and governance as well as money.

The entrepreneur must consider valuation, liquidation preferences, anti-dilution provisions, participation rights, board control, vesting, founder commitments, and future financing implications. A high headline valuation may be less attractive than a lower valuation with simpler and fairer terms.

6. A Practical Framework for Financing Decisions

A sound financing decision begins with the investment project, not with a preferred instrument. Management should forecast operating cash flows under base, pessimistic, and stress scenarios. It should then determine the amount, timing, currency, seniority, and flexibility required.

A useful sequence is:

1. Assess business risk. Examine demand volatility, margins, competition, technology, regulation, and operating leverage.
2. Estimate sustainable debt capacity. Consider recurring cash flow, asset collateral, tax capacity, interest coverage, debt maturities, and covenant headroom.
3. Compare total economic cost. Include coupon or dividend, issuance fees, underwriting, monitoring, collateral, expected distress costs, and potential dilution.
4. Evaluate control and governance. Analyze voting rights, board seats, veto rights, reporting requirements, and shareholder concentration.
5. Match maturity to asset life. Long-lived assets should not normally depend entirely on short-term refinancing.
6. Test resilience. Model adverse sales, margin, interest-rate, exchange-rate, and refinancing scenarios.
7. Preserve flexibility. Consider undrawn facilities, covenant headroom, optional repayment, and access to future capital.
8. Review legal and ethical obligations. Provide accurate disclosure and treat all investors fairly.

The relevant cost is not merely the stated interest rate. For debt, management should consider the after-tax cost, fees, collateral, covenants, expected distress, and refinancing. For equity, it should consider flotation costs, dilution, control, and the return required by investors. WACC is useful for value-creating investment appraisal, but it should not replace project-specific risk analysis.

7. Applied Case: Northbridge Components Ltd.

This is an illustrative case.

Background

Northbridge Components manufactures specialized equipment for renewable-energy projects. It plans to invest £12 million in automated production and expects stable long-term demand, but sales could vary substantially during the two-year installation period. Existing debt is £8 million, interest-bearing at a mostly fixed rate. The company is profitable and pays corporation tax. Its shareholders prefer not to dilute control, while its principal bank is concerned about leverage and requests a maintenance covenant.

Problem

Management is considering three alternatives: an additional secured term loan, a private-equity investment for a minority stake, or a convertible bond. The loan has the lowest explicit initial cost but would raise fixed payments and require security over production assets. Private equity would provide operational expertise and no mandatory interest, but investors require a board seat and preferred return. The convertible would carry a lower coupon than ordinary debt but could dilute shareholders if the share price rises.

Analysis

Northbridge first calculates the project’s operating sensitivity. Automation increases fixed operating costs, so DOL is expected to rise. The company therefore should not evaluate the loan solely by comparing its coupon with the expected return on the investment. It must test whether cash flow can cover interest and scheduled principal when sales are 20% below forecast.

The loan’s advantages are tax-deductible interest, no immediate ownership dilution, and a clear maturity. Its risks are increased DFL, covenant breach, collateral loss, and refinancing pressure. Private equity lowers distress risk and may improve operational performance, but the investor’s preferred return and governance rights reduce the value retained by existing shareholders. The convertible shares risk between the two: its coupon is lower, but future conversion may transfer value to new shareholders.

Approach and solution

The board adopts a staged structure. It funds part of the investment with retained earnings, obtains a moderate term loan with a maturity matching the useful life of the equipment, and uses a smaller convertible issue for the uncertain expansion component. The loan includes a reasonable covenant cure period and a fixed-rate portion. Management also negotiates an undrawn revolving facility for working-capital volatility.

The financing package is stress-tested for lower sales, higher interest rates, delayed customer payments, and slower conversion of the instrument. Disclosures explain potential dilution and covenant consequences. The board establishes quarterly monitoring of interest coverage, cash conversion, debt maturity, and covenant headroom.

Outcome and learning points

The blended approach does not produce the lowest initial stated cost under every forecast. It does, however, reduce dependence on one risk-bearing claim, preserve some control, and protect liquidity during the installation phase. The case demonstrates that an optimal structure is conditional: it depends on operating risk, financial flexibility, investor rights, tax position, and the distribution of uncertain future outcomes.

8. Governance, Regulation, Ethics, and Contemporary Developments

Financing decisions are governed by company law, securities regulation, listing rules, lending standards, accounting requirements, and insolvency law. Directors generally owe duties to the company and must consider solvency, proper purpose, conflicts of interest, and adequate disclosure. Misrepresenting forecasts, concealing covenant risks, selectively disclosing material information, or structuring securities to mislead investors is unethical and may be unlawful.

Environmental, social, and governance considerations increasingly affect financing costs and access. Sustainability-linked loans may adjust pricing according to verified performance targets. Such instruments require precise metrics, independent verification, and protection against weak or cosmetic targets. Green bonds require credible use-of-proceeds systems and reporting. The label should not substitute for substantive environmental performance.

Technology improves financing analysis through integrated cash-flow forecasting, covenant dashboards, scenario modelling, and automated document review. AI can identify patterns in financial statements and simulate financing scenarios, but its outputs depend on data quality and model assumptions. Human oversight remains necessary because rare distress events, regime changes, legal interpretation, and ethical judgments are not reliably captured by historical data alone. Firms should document model governance, protect confidential information, test for bias, and prevent automated recommendations from becoming unreviewed financing decisions.

Challenges and Limitations

No single theory explains all observed capital structures. Trade-off theory emphasizes tax and distress costs, pecking-order theory emphasizes information asymmetry, signaling theory emphasizes communication, and agency theory emphasizes conflicts of interest. These perspectives are complementary rather than mutually exclusive.

EBIT–EPS analysis is static and focuses on accounting earnings. It can encourage excessive debt if managers ignore the probability-weighted cost of distress and the market’s valuation of risk. DOL and DFL are point estimates and may become unstable near break-even or when fixed costs, interest rates, prices, and volumes change. WACC depends on estimates of market values and required returns and is inappropriate when project risk differs materially from firm risk.

In practice, firms also face imperfect markets, changing tax rules, lender concentration, financial crises, geopolitical risk, foreign exchange exposure, and refinancing shocks. Consequently, financing should be reviewed continuously rather than treated as a one-time optimization exercise.

Best-Practice Checklist

• Use market values where valuation-based capital-structure analysis is required.
• Match financing maturity and currency to the assets and cash flows being financed.
• Assess both normal and stressed cash-flow coverage.
• Distinguish accounting EPS benefits from economic value creation.
• Quantify covenants, collateral, fees, embedded options, and potential dilution.
• Maintain liquidity reserves and avoid excessive maturity concentration.
• Explain risks and conflicts transparently to investors and lenders.
• Use independent review for complex hybrids and sustainability-linked claims.
• Treat models, including AI tools, as decision support rather than substitutes for judgment.

Chapter Summary

Capital structure determines how a firm divides financial claims, risk, control, and cash-flow obligations among debt and equity providers. Operating leverage arises from fixed operating costs, while financial leverage arises from fixed financial charges; together they can substantially magnify shareholder returns and losses. DOL, DFL, DCL, break-even analysis, and EBIT–EPS comparisons provide useful quantitative tools, but they must be interpreted alongside cash-flow risk and financial flexibility.

Modigliani–Miller establishes that capital structure is irrelevant under highly restrictive perfect-market assumptions. Taxes, distress costs, information asymmetry, signaling, and agency conflicts explain why financing can affect value in the real world. Trade-off theory balances tax benefits against expected distress costs; pecking-order theory emphasizes internal funds and information asymmetry; signaling theory interprets financing choices as information; and agency theory examines conflicts among managers, shareholders, and lenders.

Debt, bonds, equity, preferred shares, hybrids, private equity, and venture capital differ in payment priority, control, maturity, risk, disclosure, and flexibility. The best financing decision matches the instrument to the firm’s operating risk, asset life, cash-flow capacity, strategic objectives, governance requirements, and regulatory duties. Sound practice uses stress testing, transparent disclosure, covenant monitoring, and disciplined human oversight of analytical technology.

Key Terms

Capital structure: The mix of long-term debt, preferred equity, and ordinary equity used by a firm.

Operating leverage: Sensitivity of EBIT to changes in sales caused by fixed operating costs.

Financial leverage: Sensitivity of common shareholders’ earnings to changes in EBIT caused by fixed financial charges.

Degree of operating leverage: Contribution margin divided by EBIT at a specified activity level.

Degree of financial leverage: Sensitivity measure relating changes in EBIT to changes in common earnings.

Degree of combined leverage: Product of operating and financial leverage.

EBIT–EPS analysis: Comparison of earnings per share under alternative financing plans at different EBIT levels.

Indifference point: EBIT level at which two financing plans produce the same EPS.

Financial distress: Difficulty meeting contractual financial obligations.

Trade-off theory: Theory balancing tax benefits of debt against expected distress and related costs.

Pecking-order theory: Theory proposing a preference for internal funds, then debt, then external equity.

Signaling theory: Perspective that financing choices communicate information to investors.

Agency cost: Cost arising from conflicts among managers, shareholders, and lenders.

Tax shield: Reduction in tax liability associated with deductible interest expense.

WACC: Weighted average cost of debt and equity capital, using appropriate market-value weights.

Convertible bond: Debt instrument that may be converted into ordinary shares under specified terms.

Private placement: Sale of securities to a limited group of investors.

Venture capital: Equity financing for high-growth, high-risk emerging firms.

Covenant: Contractual restriction or requirement in a lending agreement.

Financial flexibility: Capacity to obtain funds and respond to opportunities or shocks in the future.

Review Questions

Short Answer Questions

1. What is the difference between operating leverage and financial leverage?
2. State the assumptions underlying the basic EBIT–EPS formula.
3. Why does interest create a tax shield in many corporate tax systems?
4. What is meant by the pecking order of finance?
5. Identify two direct and two indirect costs of financial distress.

Long Answer Questions

1. Explain the Modigliani–Miller propositions with and without corporate taxes, including their assumptions and limitations.
2. Compare trade-off, pecking-order, signaling, and agency theories of capital structure.
3. Discuss the advantages and disadvantages of bonds, ordinary equity, preferred shares, and convertible securities.
4. Explain why a firm with high operating leverage may need to adopt a conservative debt policy.
5. Develop a comprehensive framework for evaluating a long-term financing proposal.

Analytical / Application Questions

1. A firm has sales of £900,000, variable costs of £540,000, fixed operating costs of £240,000, and interest of £30,000. Calculate EBIT, DOL, DFL, and DCL, assuming no preferred stock. Interpret the result.
2. A project costing £4 million can be financed either by issuing 200,000 shares or by borrowing £4 million at 7%. Existing shares total 600,000, the tax rate is 25%, and expected EBIT is £900,000. Calculate EPS under each plan and determine which plan produces the higher EPS. What additional qualitative risks must be assessed?
3. A growing technology firm has volatile cash flows, few tangible assets, and valuable expansion opportunities. Recommend a financing mix using at least two capital-structure theories and explain how governance and distress risk affect your recommendation.

Multiple Choice Questions with Answers

Question 1

A firm has sales of £500,000, variable costs of £300,000, and fixed operating costs of £120,000. What is its degree of operating leverage?

A. 1.50

B. 2.00

C. 2.50

D. 3.33

Correct Answer: C. 2.50

Question 2

Under the basic EBIT–EPS model, which item is deducted from EBIT before applying the tax rate?

A. Ordinary dividends

B. Interest expense

C. Flotation cost

D. Retained earnings

Correct Answer: B. Interest expense

Question 3

In the no-tax Modigliani–Miller model, leverage does what to total firm value under perfect-market assumptions?

A. Always increases it

B. Always decreases it

C. Leaves it unchanged

D. Makes it equal to zero

Correct Answer: C. Leaves it unchanged

Question 4

Trade-off theory primarily balances the tax benefits of debt against:

A. Employee bonuses

B. Expected financial distress costs

C. Ordinary share voting rights

D. Inventory turnover

Correct Answer: B. Expected financial distress costs

Question 5

Which financing hierarchy is most consistent with pecking-order theory?

A. Equity, preferred shares, debt, retained earnings

B. Debt, equity, retained earnings, hybrids

C. Retained earnings, debt, then external equity

D. Venture capital, bonds, retained earnings, equity

Correct Answer: C. Retained earnings, debt, then external equity

Question 6

A convertible bond is best described as:

A. An ordinary share with mandatory interest

B. Debt that may be converted into ordinary shares

C. A short-term trade payable

D. A secured bank deposit

Correct Answer: B. Debt that may be converted into ordinary shares

Question 7

Which condition generally increases a firm’s sustainable debt capacity?

A. Highly volatile cash flows and intangible assets

B. Stable cash flows and substantial collateral

C. Concentrated short-term maturities

D. Persistent operating losses

Correct Answer: B. Stable cash flows and substantial collateral

Question 8

If EBIT is £80,000 and interest expense is £20,000, with no preferred stock, what is DFL?

A. 0.25

B. 1.33

C. 2.50

D. 4.00

Correct Answer: B. 1.33

Question 9

Which is an indirect cost of financial distress?

A. Court filing fees

B. Legal advisory fees

C. Loss of customers concerned about continuity

D. Bond coupon stated in the contract

Correct Answer: C. Loss of customers concerned about continuity

Question 10

Why should WACC not be applied automatically to every project undertaken by a firm?

A. WACC never includes debt

B. WACC is unrelated to market values

C. Projects may have risks different from the existing business

D. WACC can only be used by banks

Correct Answer: C. Projects may have risks different from the existing business