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13model 10/6/2009 8:15 12/2/2002 Chapter 13. Model for Capital Structure and Leverage In Chapter 5, we introduced the idea that risk has two principal components, market risk and stand-alone risk. Market risk is measured by beta, while stand-alone risk consists of both market risk plus an element of risk that can be eliminated through diversification. In this chapter, we introduce two new dimensions of risk, business risk and financial risk. Business risk is the risk inherent in the firm's operations, and it would be there even if the firm used no debt. Financial risk is the additional risk borne by the stockholders as a result of the use of debt. BUSINESS RISK AND OPERATING LEVERAGE Operating Leverage reflects the amount of fixed costs embedded in a firm's operations. Thus, if a high percentage of a firm's costs are fixed, hence continue even if sales decline, then the firm is said to have high operating leverage. High operating leverage produces a situation where a small change in sales can result in a large change in operating income. The following example compares two operational plans with different degrees of operating leverage. Using the input data given below, we examine the firm's profitability under two operating plans, in different states of the economy. The probabilities of the economic states are also given in the example. Input Data Plan A Plan B Low FC High FC Price \$2.00 \$2.00 Product sells at same price regardless of how it is produced. Variable costs \$1.50 \$1.00 Plan A has high variable costs; it doesn't use labor-saving equipment. Fixed costs \$20,000 \$60,000 Plan B has high fixed costs (depreciation) due to the use of labor-saving equipment. Total assets \$200,000 \$200,000 Tax Rate 40% 40% A's break-even units = 40,000. See table. B's breakeven units = 60,000. See calculation below. Operating Performance Plan A: Low Fixed, High Variable Costs Plan B: High Fixed, Low Variable Costs Data Applicable to Both Plans Net Op Profit Return on Net Op Profit Return on Units Dollar Operating Operating After Taxes Equity Operating Operating After Taxes Equity Demand Probability Sold Sales Costs Profit (EBIT) (NOPAT) (ROE) Costs Profit (EBIT) (NOPAT) (ROE) Terrible 0.05 0 \$0 \$20,000 (\$20,000) (\$12,000) -6.0% \$60,000 (\$60,000) (\$36,000) -18.0% Poor 0.2 40,000 \$80,000 \$80,000 \$0 \$0 0.0% \$100,000 (\$20,000) (\$12,000) -6.0% Average 0.5 100,000 \$200,000 \$170,000 \$30,000 \$18,000 9.0% \$160,000 \$40,000 \$24,000 12.0% Good 0.2 160,000 \$320,000 \$260,000 \$60,000 \$36,000 18.0% \$220,000 \$100,000 \$60,000 30.0% Wonderful 0.05 200,000 \$400,000 \$320,000 \$80,000 \$48,000 24.0% \$260,000 \$140,000 \$84,000 42.0% Expected Values: 100,000 \$200,000 \$170,000 \$30,000 \$18,000 9.0% \$160,000 \$40,000 \$24,000 12.0% Standard Deviation (SD):* 49,396 \$98,793 \$24,698 7.41% \$49,396 14.82% Coefficient of Variation (CV): 0.49 0.49 0.82 0.82 1.23 1.23 A B C D E F G H I J K L M 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42

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*We used the function wizard rather than the formula to calculate the standard deviation. Click fx>Statistical>STDEVP. You must scroll down the dialog box to make all the entries.
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