Session2-Chapter15-16[1]

Session2-Chapter15-16[1] - CapitalStructureDecisions...

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Capital Structure Decisions Session 2:  Chapters 15 and 16
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Topic Outline Business Risk Operating Leverage Financial Risk Financial Leverage Capital Structure Theory Factors affecting Capital Structure  Decisions
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Capital Structure The proportion of debt (short and long- term), preferred stock, and common  stock used to finance the firm’s assets. Changes in capital structure affects  the  distribution of the firm’s operating  income among the firm’s claimants:  debtholders, preferred shareholders,  and common stockholders.
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Business Risk The risk inherent in a firm’s operations.  It is a function of the variability (uncertainty) in  the firm’s future expected return on invested  capital (ROIC). It is measured by the standard deviation of  the firm’s Return on Invested Capital or  Return on  Equity (ROE).
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Business Risk Probability EBIT E(EBIT) 0 Low risk High risk
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Measuring Business Risk ROIC = Net Income + After Tax Interest     Capital If the firm uses no debt ROE = ROIC: ROE = ROIC = Net Income             Common Equity Business Risk of a debt free =   σ ROE
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Factor’s Influencing Business  Risk Demand variability (unit sales)  Sales (output) price variability Input cost variability Price Elasticity Foreign risk exposure Degree of operating leverage (DOL)
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Operating Leverage The percentage of fixed (versus  variable) costs in the firm’s  operating  structure. Fixed operating costs do not change  with the  level of sales. The higher the proportion of fixed costs  within a firm’s overall cost structure, the  greater the  operating leverage .
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Operating Leverage Higher operating leverage leads to more  business risk, because a small sales  decline causes a larger profit decline. Sales $ Rev. TC FC Q BE Sales $ Rev. TC FC Q BE Profit }
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Probability EBIT L Low operating leverage High operating leverage EBIT H In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.
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Operating Leverage and  Business Risk The greater the degree of operating  leverage the  more sensitive ROE will  be to changes in sales. The more variable ROE is, the greater  the business risk.
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The higher the degree of operating  leverage the higher a firm’s business  risk. B-E Analysis:  shows the relationship  between revenues, fixed and variable  costs, and EBIT at various sales levels. The higher the percentage of fixed 
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This note was uploaded on 02/14/2011 for the course FINANCE 620 taught by Professor Halstead during the Spring '09 term at UMBC.

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Session2-Chapter15-16[1] - CapitalStructureDecisions...

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