Topic 12 _Capital Structure_2008-3

Topic 12 _Capital Structure_2008-3 - 12-1Topic 12Capital...

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Unformatted text preview: 12-1Topic 12Capital Structure and LeverageBusiness vs. financial riskOptimal capital structureOperating leverageCapital structure theory12-2Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?Note that business risk does not include financing effects.What is business risk?ProbabilityEBITE(EBIT)Low riskHigh risk12-3What determines business risk?Uncertainty about demand (sales)Uncertainty about output pricesUncertainty about costsProduct, other types of liabilityOperating leverage12-4What is operating leverage, and how does it affect a firms business risk?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.12-5Effect of operating leverageMore operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.What happens if variable costs change?Sales$Rev.TCFCQBESales$Rev.TCFCQBE}Profit12-6Using operating leverageTypical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.ProbabilityEBITLLow operating leverageHigh operating leverageEBITH12-7What is financial leverage?- Financial risk?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.12-8Business risk vs. Financial riskBusiness 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.12-9An example:Illustrating effects of financial leverageTwo firms with the same operating leverage, business risk, and probability distribution of EBIT.Only differ with respect to their use of debt (capital structure).Firm U Firm LNo debt $10,000 of 12% debt$20,000 in assets $20,000 in assets40% tax rate 40% tax rate12-10Firm U: Unleveraged Economy Bad Avg. GoodProb.0.250.500.25EBIT$2,000$3,000$4,000Interest 0 0 0EBT$2,000$3,000$4,000Taxes (40%) 800 1,200 1,600NI$1,200$1,800$2,40012-11Firm L: Leveraged Economy Bad Avg. GoodProb.*0.250.500.25EBIT*$2,000$3,000$4,000Interest...
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This note was uploaded on 10/20/2010 for the course BADM 115 taught by Professor Bajeux during the Spring '08 term at GWU.

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Topic 12 _Capital Structure_2008-3 - 12-1Topic 12Capital...

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