case3_03 - Capital Structure Policy Financial management...

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Capital Structure Policy Financial management and policy Case 3, week 4 University of Maastricht Faculty of Economics and Business Administration Maastricht, 19 th of November 2003 Danner, W. I 136964 Kuijt, R.J. I 130885 Steenvoorden, W.J.M. I 178829 Course Code: 6010v Group number: 7 Subgroup number: 1 Tutor: B. Pavlov
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a) The risk for common stockholders of a firm without debt is called business risk. The business risk stems from the uncertainties concerning future operating profits and investment requirements. Financial risk in contrast is the additional risk for common stockholders which evolves from a capital structure where debt is included. b) A measure of the business risk on a stand-alone basis is the standard deviation of ROIC. ROIC is calculated by dividing the sum of net income to common stockholders and the after- tax interest payments, with capital. In order to measure the financial risk, one can compare two firms, one of which is leveraged, and one which is unleveraged. The firms have to be identical in demand, book value, EBIT, and taxed at the same rate. The difference in the standard deviation between the levered and the unlevered firm is the standard deviation for financial risk. c) The beta coefficient measures a firm’s market risk. For a levered firm the beta coefficient can be calculated by the following formula: b = b u [1+(1-T)(D/S)]. According to this formula, the beta of a levered firm will increase as the operating leverage increases. As can be seen, the unlevered beta is a constant. The increase in the beta from an unlevered firm to that of the levered firm reflects the increase in financial risk that this leverage holds. d) According to Brigham and Daves (2004), other things held constant, the higher the firm’s operating leverage, the higher its business risk. The higher the amount of debt a company has, the higher the volatility of the returns on equity will be, and therefore the higher the business risk will be. 2 a)+b)
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This note was uploaded on 11/16/2009 for the course F 3033 taught by Professor Hh during the Spring '09 term at Maastricht.

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case3_03 - Capital Structure Policy Financial management...

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