Capital Structure and Leverage Concept for Agribusiness
Capital structure is the composition of common stock corporate, preferred stock, and debt that a corporation plans to acquire. An optimal capital structure bridges the gap between the return of risk to optimize the stock price of the company. Corporate capital consists of common stock, preferred stock, and debt (debenture/bond). The finance manager must be aware of Capital Structure and Leverage Concept for Agribusiness.
The capital structure includes a balance between risk and return:
- Debt places stockholders at risk.
- Debt results in a much higher projected return on equity.
Factors affecting the decision on capital structure:
1. Business risk
It refers to the danger of the assets if no collateral is used by the company. Business risk is calculated by the uncertainty inherent in the Potential Return on Assets ( ROA) predicted the percentage of the company. The higher the risk to the company, the lower the optimum debt level.
- If a high percentage of a company’s costs are set, then the company is subjected to a reasonably high level of business risk.
- A high level of operating leverage, other variables kept stable, means that a relatively minor shift in revenue results in a substantial improvement in return on equity (ROE).
- The higher the operating leverage of a company, the greater the risk of its business as calculated by the standard deviation of its expected ROE .
2. Financial risk
Financial risk exists when a business makes use of debt. It is the added risk that common stockholders face as an outcome of the firm’s decision to use debt.
- Debt increases the firm’s expected ROE, when ROA exceeds the cost of debt (ROA > kD)
- Standard deviation (σ) of ROE, if the firm uses zero financial leverage, σ ROE(U), is a quantify of the firm’s business risk.
- σ ROE at any debt level is a measure of the total risk borne by stockholders.
- If the firm does not use any financial leverage, σ ROE = σ ROE(U).
- If the firm uses debt, then σ ROE > σ ROE(U) as the business risk is being concentrated on shareholders.
- The dissimilarity between σ ROE and σ ROE (U) is a measure of risk rising outcome of financial leverage:
| Total risk [σ ROE] – Business risk [σ ROE(U)] = Financial risk [σ ROE – σ ROE(U)] |
- Both operational leverage and financial leverage operate in the same manner as usual. They lift predicted ROE and increase the risk to stockholders as well.
- Operating leverage alone determines the business risk of the company while financial leverage alone affects the financial risk of the company, and both affect the overall risk of the company.
3. Tax treatment
Interest is tax-deductible which reduces the effective debt expense.
4. Financial flexibility
5. Managerial conservatism
Leverage
Operating Leverage
Operating leverage refers to the degree to which a firm’s service uses fixed costs. It implies magnifying EBIT gains and losses by a transition occurring in sales.
Financial Leverage
The degree to which fixed-revenue instruments are used in the capital structure applies to financial leverage. Financial leverage is generated by funding sources that have fixed costs.
Combined Leverage
It refers to total leverage which consists of operational leverage and financial leverage.
