6thCh13P - CHAPTER13 Businessvs.financialrisk...

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1 CHAPTER 13 Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory
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2 Uncertainty 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? Probability EBIT E(EBIT) 0 Low risk High risk
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3 What is operating leverage, and how  does it affect a firm’s 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.
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4 Effect of operating leverage More 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. TC FC Q BE Sales $ Rev. TC FC Q BE } Profit
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5 Operating Leverage Operating breakeven when ROE=0 EBIT=PQ-VQ-F Solving for breakeven quantity: BE F Q P-V =
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6 Uses of Breakeven Analysis Expansion of operations New Products New Technology Change in Price
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7 Finding the Breakeven  Quantity Lotus Machinery expects to sell 10,000  widgets per month.  Its fixed costs are  $2,000 and each widget costs $1.50 in  variable costs.   What price must Lotus charge to break  even?
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8 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.
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9 Importance of the Financing  Decision Optimal capital structure maximizes firm  value. The value of a real asset is determined  by the level and risk of the cash flows that the  asset is expected to generate the way the asset is financed
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10 Miller and Modigliani on Debt Miller and Modigliani (M&M) showed  that the firm value is independent of  financial policy if there are  no taxes no transaction or information costs the real investment policy of the firm is  fixed
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12
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13 An example: Illustrating effects of financial leverage
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