Term paper v1 009 final

[LEVERAGE AND CAPITAL STRUCTURE IN HEITECH PADU BERHAD] April 13, 2013
TERM PAPER MANAGERIAL FINANCE | FIN745 1
Contents
1.0 ABSTRACT......................................................................................................................... 2
2.0 INTRODUCTION ............................................................................................................... 2
2.1 Organization Background ................................................................................................ 2
3.0 SCOPE & METHOD OF STUDY ...................................................................................... 3
3.1 Scope of Study ................................................................................................................. 3
3.2 Method of Study............................................................................................................... 4
4.0 LITERATURE REVIEW .................................................................................................... 5
4.1 Types of Leverage............................................................................................................ 5
5.0 ANALYSIS RESULT.......................................................................................................... 6
5.1 Degree of Operating Leverage in 5 years (2007-2011) ....................................................... 6
5.2 Degree of Financial Leverage in 5 years (2007-2011)..................................................... 7
5.3 Degree of Total Leverage in 5 years (2007-2011)........................................................... 8
5.4 Market Price Trend of HeiTech Padu Bhd. (2007-2011)................................................. 9
6.0 CONCLUSION.................................................................................................................. 10
6.1 Degree of Operating Leverage (DOL) ........................................................................... 10
6.2 Degree of Financial Leverage (DFL)............................................................................. 10
6.3 Degree of Total Leverage............................................................................................... 11
6.4 Comparison of Capital Structure to Market Price Trend of HeiTech Padu Bhd. (2007-
2011) 12
7.0 RECOMMENDATION ..................................................................................................... 14
7.1 Degree of Operating Leverage (DOL) ........................................................................... 14
7.2 Degree of Financial Leverage (DFL)............................................................................. 14
7.3 Degree of Total Leverage (DTL) ................................................................................... 15
7.4 Investor Reaction to the Market Price Trend in ‗HeiTech Padu Bhd.‘ (2007-2011).... 16
8.0 REFERENCES .................................................................................................................. 17
9.0 APPENDIX........................................................................................................................ 18
9.1 Performance Highlight of HeiTech Padu Bhd. .............................................................. 18
9.2 Other Highlight .............................................................................................................. 20

1.0 ABSTRACT
This paper investigates the relationship of capital structure and corporate performance of firm
which focuses on HeiTech Padu Berhad. HeiTech Padu Berhad is listed in Main Board of Bursa
Malaysia. The analysis shows high volatility in total business risk in HeiTech Padu Berhad in
five years duration from 2007 to 2011. Despites the volatility, the result however proves that
there is a positive relationship between capital structure - degree of total leverage and corporate
performance on market share.
2.0 INTRODUCTION
Capital Structure refers to the firm‘s financial framework which consists of the debt and equity
used to finance the firm. Capital Structure is essential on how a firm finances its overall
operations and growth by using different resources of fund. In the other word, the definition
taken from Saad (2010) ; the capital structure is a mixture of a company‘s:
1) Debt – long term and short term
2) Equity – common equity and preferred equity
3) Hybrid – combination of debt and equity
2.1 Organization Background
HeiTech Padu Berhad, a public listed company on the main board of the Bursa Malaysia is
Malaysia‘s leading ICT Solutions Provider. HeiTech Padu Berhad was incorporated in 5th
August 1994 started as an Electronic Data Processing Division ("EDP") of Permodalan Nasional
Berhad ("PNB"). In 1st January 1998 the company began its journey as an independent
commercial entity. PNB Information Technologies Sdn. Berhad (―PNB IT‖) was retained as the
name of the Company.

In 24th March 2000, the company changed its name to HeiTech Padu Berhad (―HeiTech‖) in line
with its status as a public listed company. In 20th November 2000, HeiTech began its first
trading on the main board of the Kuala Lumpur Stock Exchange (―KLSE‖) currently known as
Bursa Malaysia Securities Berhad. In 2006 HeiTech Padu Berhad ventured into media and
content development business through the acquisition of Electronic Media Airtime Services Sdn.
Bhd. HeiTech became the first local IT company to be certified with Information Security
Management System (―ISMS‖) (ISO/IEC 27001:2005) from SIRIM QAS International.
In 2010, HeiTech enhanced its business portfolio in the Middle East and North Africa by the
incorporation of Al Afaaq Total Solutions LLC, Dubai, United Arab Emirates (UAE). HeiTech
collaborated with Microsoft Corp. to explore the possibility of providing state of- the-art
IT based consumer health services in Malaysia. In 2011 HeiTech Padu Berhad extended its
business in the Asia-Oceania region with the acquisition of Cinix 1 Pty. Ltd. in Brisbane,
Australia. HeiTech also collaborated with Thales Nederland, a leading global technology player
in integrated naval systems to explore the possibility of developing Combat Management system
in Malaysia. As on 31st August 2011, the paid up capital for HeiTech Padu Berhad is
RM100,716,600. (www.heitech.com.my/about-corporate-milestone.php).
3.0 SCOPE & METHOD OF STUDY
3.1 Scope of Study
The purpose of this study is to use the Degree of operating leverage (DOL), Degree of financial
leverage (DOL) and Degree of total leverage (DTL) in HeiTech Padu for years starting from
2007 until 2011 as the determinant of risk of common stock and also to find the relationship
between the company‘s financial leverage and market price.

3.2 Method of Study
The data and information was obtained from HeiTech Padu‘s income statement and balance
sheet in 5 years starting from 2007 to 2011. The information in financial statements was being
evaluated and value for DOL, DFL and DTL were calculated using formula as stated below:
 Degree of = % Change of EBIT
Operating Leverage % Change in Sales
 Degree of = % Change of EPS
Financial Leverage % Change in EBIT
 Degree of = % Change of EPS
Total Leverage % Change in Sales
Below are the information that we were able to obtain from HeiTech Padu income statement and
balance sheet.
Table 1: Calculation of Degree of Operating Leverage, Degree of Financial Leverage and
Degree of Total Leverage from 2006 to 2011.
Items 2011 2010 2009 2008 2007 2006
Sales 353656 433910 421968 458973 424016 335037
EBIT 13369 22987 22605 42426 29973 18566
%Change EBIT -0.42 0.02 -0.47 0.42 0.61 -
%Change Sales -0.18 0.03 -0.08 0.08 0.27 -
EPS 4.00 8.83 9.93 29.66 15.36 6.11
%Change EPS -0.55 -0.11 -0.67 0.93 1.51 -
DOL 2.26 0.60 5.79 5.04 2.31 -
DFL 1.31 -6.56 1.42 2.24 2.46 -
DTL 2.96 -3.91 8.25 11.29 5.70 -

4.0 LITERATURE REVIEW
4.1 Types of Leverage
In finance, leverage is a term for any technique to multiply gains and losses. Leverage can be
divided or classified as follow, (Gitman & Zutter, 2012):
Operating leverage
Operating leverage may be defined as the relationship between the firm‘s sales revenue and its
earnings before interest and taxes (EBIT) or operating profit. When costs of operations are
largely fixed, small changes in revenue will lead to much larger changes in EBIT.
Financial leverage
Financial leverage is related with the financing activities of a firm, it is defined as the
relationship between the firm‘s EBIT and its common stock earnings per share (EPS). On the
income statement, you can see that the deductions taken from EBIT to get to EPS include
interest, taxes, and preferred dividends. Taxes are clearly variable, but interest expense and
preferred dividends are usually fixed. When these fixed items are large, small changes in EBIT
produce larger changes in EPS.
Total leverage
The combination of operating leverage and financial leverage is called total leverage. It is
concerned with the relationship between the firm‘s sales revenue and EPS.

5.0 ANALYSIS RESULT
5.1 Degree of Operating Leverage in 5 years (2007-2011)
.
Graph 1 : Degree of Operating Leverage from 2007 to 2011
The above graph shows the result of Degree of Operating Leverage (DOL) calculated from 2007
until 2011 (for 5 years). DOL calculated as 2.31 in 2007, 5.04 in 2008, 5.79 in 2009, 0.60 in
2010, and 2.26 in 2011. The total average DOL calculated in 5 years is 3.20
2.31
5.04
5.79
0.60
2.26
3.20
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
2007 2008 2009 2010 2011
Degree of Operating Leverage Average DOL in 5 years

5.2 Degree of Financial Leverage in 5 years (2007-2011)
Graph 2 : Degree of Financial Leverage from 2007 to 2011
The above graph shows the result of Degree of Financial Leverage (DFL) calculated from 2007
until 2011 (for 5 years). DFL calculated as 2.46 in 2007, 2.24 in 2008, 1.42 in 2009, -6.56 in
2010, and 1.31 in 2011. The total average DFL calculated in 5 years is 0.18
2.46
2.24
1.42
-6.56
1.31
0.18
-8.00
-7.00
-6.00
-5.00
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
2007 2008 2009 2010 2011
Degree of Financial Leverage Average DFL in 5 years

5.3 Degree of Total Leverage in 5 years (2007-2011)
Graph 3 : Degree of Total Leverage from 2007 to 2011
The above graph shows the Degree of Total Leverage (DTL) calculated from 2007 until 2011
(for 5 years). DTL calculated as 5.70 in 2007, 11.29 in 2008, 8.25 in 2009, -3.91 in 2010, and
2.96 in 2011. The total average DTL calculated in 5 years is 4.86
5.70
11.29
8.25
-3.91
2.96
4.86
-6.00
-4.00
-2.00
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
2007 2008 2009 2010 2011
Degree of Total Leverage Average DTL in 5 years

5.4 Market Price Trend of HeiTech Padu Bhd. (2007-2011)
Graph 4 : Market Price Trend of HeiTech Padu against KLSE
(http://www.heitech.com.my/investor-relations.php)
The above graph shows the market price trend of HeiTech Padu Bhd. (blue line) and the KLSE
Index Price (red line) from the year 2008 until 2013. The market price of HeiTech Padu Bhd is
only consistent to the KLSE Index until early 2009. Middle of 2009 the market price trend is not
consistent anymore. Here the market price of HeiTech Padu Bhd starts declining while the KLSE
index keeps increasing until the present year 2013. At present the market price of HeiTech Padu
is at -39.8% lower than the opening price in 2004.

6.0 CONCLUSION
6.1 Degree of Operating Leverage (DOL)
For Degree of Operating Leverage, the graph shows the fluctuation in the DOL value from 2007
to 2011. DOL lowest at 0.60 in 2010 it shows the company EBIT is more stable in this year
relative to previous year. The DOL was low because very minimal change in sales value for
2009 to 2010.The highest value of DOL is 5.04 in 2009, it shows the company‘s EBIT less stable
relative to the previous year. The DOL in 2009 was high due to the changes in EBIT, as reported
in their income statement HeiTech Padu sales in software division drop by RM17million and
other income also drop by RM20 million. At the same time Opex increased by 4% from 2008
which affected the DOL value in 2009.
In 2010 the DOL more stable compared to 2009, the changes in EBIT not much different in
2010, in 2011 the operating cost increased by 2% and there was another reduction of sales in
hardware & software to almost RM9million which affected the DOL value to increase to2.96.
Average DOL for HeiTech Padu is 3.20 which are considered high. As we know DOL being
calculated as ratio of percentage change of EBIT for a given percentage change in sales, it means
that the higher the DOL value the more unpredictable the company‘s EBIT, even all the other
cost factors remain the same.
6.2 Degree of Financial Leverage (DFL)
The average Degree of Financial Leverage obtained by HeiTech Padu Berhad from 2007 to 2011
is 0.18; which is quite low for the company. Low DFL value shows less volatility of the Earning
per Share value relative to the EBIT. This is a good sign for the company, where low DFL shows
stability of the company.
The lowest DFL value is in 2011 at 1.31, represent that the company EPS is more stable in this
year relative to the previous year 2010 with minimal changes in EPS and EBIT. The highest DFL

can be clearly seen from the DFL graph, at -6.56 in year 2010. High negative value for DFL
represent that the company‘s EPS is high volatile in year 2010 in relative to year 2009.
After reviewing the Income Statement and Balance Sheet, it was learned that the negative DFL
value is caused by the reduction of EPS payment from 2009 to 2010 when EBIT increased from
2009 to 2010. The EPS is decreased suspected by the issuance of high volume new common
stock at this time.
It was stated in the annual report in 2009 that the company has offered new common stock by
417,000 units. This has caused the reduction of EPS in 2009 from RM29.66 to RM9.93.
However, at this time, the DFL ratio is low at 1.42 resulted by decreased of EBIT in 2009 in
relative to previous year, 2008.
6.3 Degree of Total Leverage
For Degree of Total Leverage the graph shows the fluctuation in the DTL value from 2007 to
2011. DTL lowest at -3.91 in 2010 it shows the company EPS is more stable in year 2009 and
2010 relative to the other years. The DTL was low because very minimal change in EPS and
Sales value for 2009 to 2010.The highest value of DTL is 11.29 in 2008, it shows the company‘s
EPS less stable relative to the previous year. The DTL in 2008 was high due to the changes in
EPS, as reported in their Annual Report HeiTech Padu has issued additional common shares by
RM426,000 in 2009, RM417,000 in 2010 and RM509,000 in 2011 which has affecting the EPS
of the company dropped from RM29.66 in 2008 to only RM4.00 in 2011.
In 2010 the DTL more stable compared to 2009, the changes in EPS not much different in 2010
only by RM1.00 but in 2011 the EPF further reduced by RM4.83due to the issuance of new
common shares which affected the DTL value to increase to 2.96.
Average DTL for HeiTech Padu is 4.86 which are considered quite high. As we know DTL
being calculated as ratio of percentage change of EPS for a given percentage change in sales, it
means that the higher the DTL value the more unpredictable the company‘s Sales, even all the
other cost factors remain the same. Factors that affecting the graph goes up and down in DTL
was due to the factors affecting in DOL and DFL.

6.4 Comparison of Capital Structure to Market Price Trend of HeiTech Padu
Bhd. (2007-2011)
Graph 5 : Comparison Market Price Trend of HeiTech Padu with Capital Structure
The above graph shows the comparison Market Price Trend of HeiTech Padu (Blue Line) with
the capital structure; Degree of Operating Leverage (Orange Line), Degree of Financial Leverage
(Green Line) and Degree of Total Leverage (Purple Line). As per available Market Price Trend
from the recent 5 years (from 2008 to 2013), therefore the comparison could only be made in the
available 4 years (2008 until 2011).
The Market Price Trend of the company shows that the price is decreasing since 2008 to almost
30% lower from the first trading price. This is consistent with our finding where in 2008 the
DTL value is high with 11.29. The Market Price of the company is decreasing until early 2009.
Therefore the DTL is still high with 8.25. After 2009 the Market Price of HeiTech Padu is
climbing and starts to stabilize. Therefore the DTL is decreasing with -3.91 in 2010 and 2.96 in
2011.

The average of DTL in HeiTech Padu is quite high (4.81) is resulted by the high DTL in 2008
and 2009. During this two year, the company‘s Market Price drop to the lowest value in previous
5 years (In 2008 there was an economic crisis which cause the KLSE index drops). Therefore it
represents that the Market Price Trend has positive relationship to the DTL, whereby when the
Market Price drops, then the DTL calculated is high, which shows the company is at risk at that
time.
Even though we are not calculating the DTL after 2011, from the trend of the HeiTech Padu
Market Price, we are predicting high DTL will be carried out in 2013, since the Market Price has
drop at beginning of this year to the lowest in the recent 5 years.
It is also questionable when we found out that the Heitech Padu Market Price is not consistence
anymore with the KLSE index growth since 2009. The Market Price of HeiTech Padu keeps
decreasing after 2011 despites of increasing KLSE index which shows the company experiencing
instability until the present year 2013.
Normally the Market Price growth on the main boards‘ company will be consistence to the
KLSE index growth. As example, below is a graph which showing the Market Price growth from
the nearest competitor company in the same business area. Their Market Price Trend show good
consistency with the KLSE Index, which show the high stability of the company business
activity.
Graph 6 : Example of Good Consistency Market Price of Company ‘X’ to the KLSE Index

7.0 RECOMMENDATION
7.1 Degree of Operating Leverage (DOL)
Degree of Operating Leverage (DOL) is one of the tools to determine the appropriate level of
operating leverage in order to get the most out of the company‘s Earnings before interest and
taxes or EBIT. The higher the operating leverage the greater the impact on the operating income
even with a small percentage change in sales.
DOL is considered important to investor, Business with high DOL is considered high risk or
volatile and Investor usually will avoid investing in business with high DOL (risky). Firm with a
high DOL sometimes has its own advantage, higher value of DOL means higher levels of fixed
operating cost and the firm tends to have a greater breakeven point and once the sales volume
exceed beyond the breakeven point its margins improve. The disadvantage of having a greater
DOL is that the firm has to achieve a higher sales volume to reach the breakeven point. For
company like HeiTech Padu with its own RND, one of the ways to reduce the DOL is by
outsourcing its RND services, with this it can lower the operating cost thus lower the DOL value.
7.2 Degree of Financial Leverage (DFL)
Degree of Financial Leverage (DFL) helps in calculating the comparative change in net income
(EBIT) caused by a change in the capital structure of business (EPS). This DFL ratio is mostly
used by the firm which is under evaluation, in order to optimize their EPS with the given certain
aim.
Theoretically, the higher ratio of DFL represents the more risks the business has, and the
company should try to balance it since high leverage possession is similar as having debts. DFL
ratio is also important to investor, whereby this formula can be even used to compare the data
from many companies. Investor will decide which company to invest in, based on the result of
how much risk is attached measured by DFL. The lowest DFL ratio shows that the company has
the most stable business activities, and have high potential for the investor to invest in their
business.

7.3 Degree of Total Leverage (DTL)
The previous two types of leverage explored can be combined into an overall measure of
leverage called total leverage. Recall that operating leverage is concerned with the relationship
between sales and operating profits, and financial leverage is concerned with the relationship
between profits and earnings per share. Total leverage is therefore concerned with the
relationship between sales and earnings per share. Specifically, it is concerned with the
sensitivity of earnings to a given change in sales. The degree of total leverage is defined as the
percentage change in stockholder earnings for a given change in sales, and it can be calculated
by multiplying a company's degree of operating leverage by its degree of financial leverage.
Consequently, a company with little operating leverage can attain a high degree of total leverage
by using a relatively high amount of debt. Therefore it is advisable that in order to have a good
DTL, HeiTech Padu Berhad should have a more stable DOL and DFL.
Total risk can be divided into two parts: business risk which represented as DOL and financial
risk which represented as DFL. Business risk refers to the stability of a company's assets if it
uses no debt or preferred stock financing. Business risk stems from the unpredictable nature of
doing business, i.e., the unpredictability of consumer demand for products and services. As a
result, it also involves the uncertainty of long-term profitability. When HeiTech Padu uses debt
or preferred stock financing, additional risk—financial risk—is placed on the company's
common shareholders. The shareholders demand a higher expected return for assuming this
additional risk, which in turn, raises a company's costs.
Business risk (DOL) and financial risk (DFL) can be adjusted to keep the total risk (DTL) at the
lowest level. Consequently, companies with high degrees of business risk tend to be financed
with relatively low amounts of debt. The opposite also holds: companies with low amounts of
business risk can afford to use more debt financing while keeping total risk at tolerable levels.
Moreover, using debt as leverage is a successful tool during periods of inflation.

7.4 Investor Reaction to the Market Price Trend in ‘HeiTech Padu Bhd.’
(2007-2011).
According to Modigliani-Miller Theorem, a financial theory stating that the market value of a
firm is determined by its earning power and the risk of its underlying assets, and is independent
of the way it chooses to finance its investments or distribute dividends. Remember, a firm can
choose between three methods of financing: issuing shares, borrowing or spending profits (as
opposed to dispersing them to shareholders in dividends). Due to the volatility and fluctuation of
DOL, DFL and DTL shown in the graphs in Clause 6.0, the financial leverage affects returns in
the market price of HeiTech Padu decreasing even lower than the KLCI index. It clearly shows
that, the investors are aware about the company‘s Capital Structure on Leverage which has
affecting the market price to reduced due to the unstable leverage results, that investing in
HeiTech Padu is a great risk to them.

8.0 REFERENCES
1) Gitman, L. J.& Zutter, C. J. (2012). Principles of Managerial Finance. Boston:
Prentice Hall.
2) Saad, N. M. (2010). Corporate Governance Compliance and the Effects to capital
Structure. International Journal of Economics and Financial , 2(1),105-114
3) Investopedia. Financial Leverage And Capital Structure Policy – Modigliani And
Miller’s Capital Structure Theories. Retrieved April 05, 2013, from
http://www.investopedia.com/walkthrough/corporate-finance/5/capital-structure/
modigliani-miller.aspx
4) Investopedia. Degree of Total Leverage. Retrieved April 05, 2013, from
http://www.investopedia.com/ exam-guide/cfa-level-1/corporate-finance/degree-
of-total-leverage.asp
5) http://www.bursamalaysia.com/market/listed-companies/company-
announcements/838978
Announcements/503125

9.0 APPENDIX
9.1 Performance Highlight of HeiTech Padu Bhd.

9.2 Other Highlight
Review from the annual report of ‗HeiTech Padu Berhad‘ in 2009, page 112.

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