CH12 - CHAPTER 12 Determining the Financing Mix Orientation...

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CHAPTER 12 Determining the Financing Mix Orientation : This chapter focuses on useful aids to the financial manager in his or her determination of the firm’s proper financial structure. It includes the definitions of the different kinds of risk, a review of break-even analysis, the concepts of operating leverage, financial leverage, the combination of both leverages, and their effect on EPS (earnings per share). Then the chapter concentrates on the way the firm arranges its sources of funds. The cost of capital-capital structure argument is highlighted in a straightforward manner without dwelling excessively on pure theory. A moderate view of the effect of financial leverage on the firm’s overall cost of capital is highlighted and explained. Later, techniques useful to the financial officer faced with the determination of an appropriate financing mix are described. Agency theory and the concept of free cash flow as they relate to capital structure determination are also discussed. An overview of actual practice is also included. I. Business risk and financial risk A. Risk has been defined as the likely variability associated with expected revenue streams. 1. Focusing on the financial decision, the variations in the income stream can be attributed to: a. The firm’s exposure to business risk. b. The firm’s decision to incur financial risk. B. Business risk can be defined as the variability of the firm’s expected earnings before interest and taxes (EBIT). 1. Business risk is measured by the firm’s corresponding expected coefficient of variation (i.e., the larger the ratio, the more risk a firm is exposed to). 180
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2. Dispersion in operating income does not cause business risk. It is the result of several influences, for example, the company’s cost structure, product demand characteristics, and intra-industry competition. These influences are a direct result of the firm’s investment decision. C. Financial risk is a direct result of the firm’s financing decision. When the firm is selecting different financial alternatives, financial risk refers to the additional variability in earnings available to the firm’s common shareholders and the additional chance of insolvency borne by the common shareholders caused by the use of financial leverage. 1. Financial leverage is the financing of a portion of the firm’s assets with securities bearing a fixed (limited) rate of return in hopes of increasing the ultimate return to the common share- holders. 2. Financial risk, is to a large extent, passed on to the common shareholders who must bear almost all of the potential inconsistencies of returns to the firm after the deduction of fixed payments. II. Break-even analysis A. The objective of break-even analysis is to determine the break-even quantity of output by studying the relationships among the firm’s cost structure, volume of output, and operating profit. 1.
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This note was uploaded on 04/16/2008 for the course FIN 100 taught by Professor N/a during the Spring '08 term at Baylor.

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CH12 - CHAPTER 12 Determining the Financing Mix Orientation...

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