Chapter15 - Chapter 15 Capital Structure Decisions: Part I...

Info iconThis preview shows pages 1–2. Sign up to view the full content.

View Full Document Right Arrow Icon
Mini Case: 15 - 1 Chapter 15 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 model. 15-1 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. (2) The 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
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 2
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 04/27/2008 for the course FINC 3333 taught by Professor Melissawilliams during the Spring '08 term at UH Clear Lake.

Page1 / 13

Chapter15 - Chapter 15 Capital Structure Decisions: Part I...

This preview shows document pages 1 - 2. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online