15 - 1
Capital Structure Decisions: Part I
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
Preface to Answers:
Students often regard capital structure as being the most difficult topic
covered in this text.
The empirical evidence on the effects of capital structure are far from
definitive, and the theory is controversial.
Academicians generally focus on market values,
which are theoretically correct, while many financial executives focus on book values, which are
theoretically questionable but in some ways easier to deal with. We wrestled with this issue, and
decided to base our Excel model strictly on market values.
This led us to use an iterative
solution process, which gets complicated.
Our better students follow along and like the
approach, because everything works out nicely.
However, our weaker and/or lazier students
don’t concentrate and get lost.
We went through the model in class, as it explains the essential
capital structure issues relatively well and also illustrates the power of computer modeling.
However, other instructors might prefer to take a less rigorous approach and skip the Excel
Business risk is the risk inherent in the firm’s operating income.
It is measured by the
standard deviation of expected future operating income.
It is affected by many factors,
including the firm’s ability to raise prices if costs increase, the extent to which sales can
be predicted, and operating leverage, which reflects the use of fixed costs, or costs that do
not decline with decreases in sales.
If a firm uses more operating leverage than an
otherwise identical second firm, then, other things held constant, its operating income and
the rate of return on assets will be less predictable, which suggests greater business risk.
The higher business risk would affect both bondholders and stockholders, although the
effect on bondholders is mitigated if the firm uses relatively little debt.
The first part of
the BOC spreadsheet model illustrates this point.
Generally, higher operating leverage is correlated with higher expected operating
income and higher returns on invested capital.
Generally speaking, since more operating
leverage means more risk, then a firm would not increase its operating leverage (through
capital budgeting decisions) unless that resulted in higher expected returns.
However, the analysis can be more complicated.
In the preceding paragraph we
implicitly assumed that the firm’s sales are independent of its use of operating leverage.
However, this might not be true.
Higher fixed costs are generally accompanied by lower
variable costs, and producers with low variable costs can, under certain conditions,
achieve a monopoly position by doing the following:
(1) Charge a price that is above
their own (low) variable cost but below the variable costs of other producers.
high cost producers find themselves in a bind.
If they do not match the low-cost
producers’ prices, they will lose market share, but if they do match this price, they will