FFM CH14 - Capital Structure and Leverage Chapter 14...

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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 14-1 What is business risk? Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Note that business risk does not include financing effects. Probability EBIT E(EBIT) Low risk (higher peak) High risk (broader peak) 14-2 What determines business risk? Uncertainty about customer demand (sales) Uncertainty about output prices (list price) What should the proce be Can it vary with raw material costs Uncertainty about input costs Product, other types of liability New product delveopment Foreign risk exposure Operating leverage (fixed costs) 14-3 What 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. 14-4 Effect of Operating Leverage More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. Also, a higher breakeven point relative to higher variable cost scenarios. Sales $ Rev. TC FC Q BE Sales $ Rev. TC FC Q BE } Profit 14-5 Plan A Plan B Breakeven Analysis Q = Fixed Cost Average sales price Variable cost per unit Plan A = $20,000 fixed cost = 40,000 units $2.00 - $1.50 14-6 Using Operating Leverage Typical situation: Can use operating leverage to get higher EBIT, but risk also increases. Probability Low operating leverage High operating leverage 14-7 What 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. 14-8 Business Risk vs. Financial Risk 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. 14-9 An Example: Illustrating Effects of Financial Leverage Two firms with the same operating leverage (level of fixed costs), business risk, and probability distribution of EBIT....
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This note was uploaded on 02/08/2011 for the course FINANCE 300 taught by Professor zhou during the Spring '08 term at Rutgers.

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FFM CH14 - Capital Structure and Leverage Chapter 14...

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