1. Leverage Mechanics
  • Operating Leverage: Driven by fixed operating costs. Measures the sensitivity of Earnings Before Interest and Taxes (EBIT) to changes in sales.
  • Financial Leverage: Driven by fixed financing costs (interest expenses). Measures the sensitivity of Earnings Per Share (EPS) to changes in EBIT:

    DFL = (%ΔEPS) / (%ΔEBIT) = EBIT / (EBIT − Interest)

2. Capital Structure Theories
Modigliani-Miller (MM) Proposition I & II (No Taxes)
In a frictionless market with no taxes, bankruptcy costs, or transaction fees, the value of the firm is completely independent of its capital structure. Levering up increases the risk and cost of equity (\(r_{s}\)), perfectly offsetting the benefit of cheaper debt.
Modigliani-Miller with Corporate Taxes
When corporate taxes are introduced, interest payments become tax-deductible. This creates an Interest Tax Shield. The value of a levered firm (\(V_{L}\)) exceeds an unlevered firm
V_L = V_U + (T × Debt)
Implication: Under this strict scenario, firms should theoretically fund themselves with 100% debt to maximize corporate value.
The Trade-Off Theory of Capital Structure
Real-world market dynamics introduce Financial Distress and Bankruptcy Costs. As debt levels climb, the probability of default increases, generating deadweight legal and operational distress costs.
  Firm Value (V)
       â–²
       │             / \  ◄── Optimal Capital Structure Point (Max Value / Min WACC)
       │            /   \
       │  MM Tax   /     \ ◄── Trade-Off Theory (Tax Shield vs. Distress Costs)
       │  Line ──►/       \
       │         /         \
       └────────────────────────────────────────► Debt-to-Equity Ratio

The Balance: The optimal capital structure is achieved at the exact inflection point where the marginal benefit of the tax shield is perfectly offset by the marginal cost of financial distress.
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