Analyzing the Relationship Between Capital Structure, Financial Leverage, and Business Risk

Abstract

The choice between debt and equity is among the most consequential decisions a firm makes. It shapes the returns earned by shareholders, the volatility of those returns, the cost of capital and the probability of financial distress. This article analyses the relationship between capital structure, financial leverage and business risk. It reviews the principal theories of capital structure: Modigliani–Miller irrelevance and its tax-adjusted extension, trade-off theory, agency theory, pecking order theory and market timing. It then explains how operating and financial leverage combine to determine the total risk borne by shareholders. Using a worked example, the article shows how a firm financed with 70 percent debt earns a return on equity of 18.67 percent when operating profit is high but suffers a negative return when operating profit is low. Its degree of financial leverage is 1.875, against 1.00 for an unlevered firm. When combined with operating leverage of 1.33, a 10 percent fall in sales reduces the levered firm’s net profit by 25 percent. A stylised model of the cost of capital illustrates how moderate leverage can minimise the weighted average cost of capital, while excessive leverage raises it. The article reviews empirical evidence on the determinants of capital structure. It then examines the Indian experience, where heavy corporate borrowing in the late 2000s contributed to a sharp deterioration in bank asset quality. Gross non-performing assets reached 10.2 percent of bank advances by September 2017. The article concludes that capital structure should be matched