ch 14 - Capital Structure and Leverage Chapter 14 Business...

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Unformatted text preview: Capital Structure and Leverage Chapter 14 Business vs. Financial Risk Optimal Capital Structure Operating Leverage Capital Structure Theory 114-1 What is business risk? Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Probability EBI T E(EBIT ) Low risk High risk 214-2 What determines business risk? Uncertainty about demand (sales) Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage 314-3 What is operating leverage, and how Operating leverage is the use of fixed costs rather than variable costs. If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage. 414-4 Effect of Operating Leverage More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. O bj1 0 2 O bj1 0 3 O bj1 0 4 O bj1 0 5 Sale s $ Rev . T C F C QB E Sale s $ Rev . T C F C QB E } Profit 514-5 Using Operating Leverage Typical situation: Can use operating leverage Probabilit y EBIT L Low operating leverage High operating leverage EBIT H 614-6 What is financial leverage? Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage. 714-7 Business Risk vs. Financial Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued. More debt, more financial risk. Concentrates business risk on stockholders. 814-8 An Example: Two firms with the same operating leverage, business risk, and probability distribution of EBIT. Only differ with respect to their use of debt 914-9 Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate Firm U: Unleveraged 1014- 10 Economy Bad Average Good Probability 0.25 0.50 0.25 EBIT $2,000 $3,000 $4,000 Interest 0 0 0 EBT $2,000 $3,000 $4,000 Taxes (40%) 800 1,200 1,600 NI $1,200 $1,800 $2,400 Firm L: Leveraged 1114- 11 Economy Bad Average Good Probability* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT...
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ch 14 - Capital Structure and Leverage Chapter 14 Business...

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