fm16 15 - then calculate the expected values. Finally,...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
Mini Case: 16 - 15 d. Explain the difference between financial risk and business risk. Answer: Business risk increases the uncertainty in future EBIT. It depends on business factors such as competition, operating leverage, etc. Financial risk is the additional business risk concentrated on common stockholders when financial leverage is used. It depends on the amount of debt and preferred stock financing. e . Now consider the fact that EBIT is not known with certainty, but rather has the following probability distribution: Economic State Probability EBIT Bad 0.25 $2,000 Average 0.50 3,000 Good 0.25 4,000 Redo the part A analysis for firms U and L, but add basic earning power (BEP), return on investment (ROI), [defined as (net income + interest)/(debt + equity)], and the times-interest-earned (TIE) ratio to the outcome measures. Find the values for each firm in each state of the economy, and
Background image of page 1
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: then calculate the expected values. Finally, calculate the standard deviation and coefficient of variation of ROE. What does this example illustrate about the impact of debt financing on risk and return? Answer: Here are the pro forma income statements: Firm U Firm L Bad Avg. Good Bad Avg. Good Prob. 0.25 0.50 0.25 0.25 0.50 0.25 EBIT $2,000 $3,000 $4,000 $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $2,000 $3,000 $4,000 $ 800 $1,800 $2,800 Taxes (40%) 800 1,200 1,600 320 720 1,120 NI $1,200 $1,800 $2,400 $ 480 $1,080 $1,680 BEP 10.0% 15.0% 20.0% 10.0% 15.0% 20.0% ROIC 6.0% 9.0% 12.0% 6.0% 9.0% 12.0% ROE 6.0% 9.0% 12.0% 4.8% 10.8% 16.8% TIE ∞ ∞ ∞ 1.7 × 2.5 × 3.3 × E(BEP) 15.0% 15.0% E(ROIC) 9.0% 9.0% E(ROE) 9.0% 10.8% σ ROIC 2.12% 2.12% σ ROE 2.12% 4.24%...
View Full Document

This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

Ask a homework question - tutors are online