Chapter 12

Chapter 12 - Chapter 12 Business and Financial Risk In this...

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Chapter 12 Business and Financial Risk In this section we separate the variation in the firm’s income stream into one of three sources 1. Choice of business line: business risk – the relative dispersion or variability in the firm’s expected earnings before interest and taxes (EBIT). The nature of the firm’s operations causes its business risk. This type of risk affected by the firm’s cost structure, product demand characteristics, and intra-industry competitive position. In capital structure theory, business risk is distinguished from financial risk 2. Choice of an operating cost structure: the mix of fixed and variable operating costs the firm pays to do business. Greater fixed operating costs (versus variable costs) increase the variability in operating earnings in response to changes in revenues. The firms mixture of fixed versus variable operating costs is largely determined by the industry in which the firm operates. This is referred to as operating risk 3. Choice of a capital structure: The source of variation in the firm’s earnings that results from its use of sources of financing that require a fixed return, such as debt financing. This is referred to as financial risk Business Risk There are four basic determinants of a firm’s business risk: 1. The Stability of the domestic economy 2. The exposure to, and stability of, foreign economies 3. Sensitivity to the business cycle 4. Competitive pressures in the firm’s industry Operating Risk Operating risk increases when the firm incurs more fixed versus variable costs Break Even Analysis 1. Allows the financial officer to determine the quantity of output that must be sold to cover all operating costs 2. To calculate the EBIT that will be achieved at various output levels.
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Chapter 12 Essential Elements of the Break Even Model Break-even analysis is a short-run concept. Two categories are fixed and variable costs Fixed Costs Fixed Costs: the costs that do not vary in total dollar amount as sales volume or quantity of output changes. Also called indirect costs - As the production volume increases, the fixed cost per unit of product falls, because the firm’s total fixed costs are spread over larger and larger quantities of output. Variable costs Variable costs: costs that are fixed per unit of output but vary in total as output changes. Also called direct costs. - There are some contributions to the coverage of fixed costs as long as the selling price per unit exceeds the variable cost per unit More on Behavior Costs Semi-variable costs: costs that may be fixed for a while, then rise sharply to a higher level as higher output is reached, remain fixed, and then rise again with further increases in production. The financial manger must identify the most relevant output range for
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This note was uploaded on 08/30/2011 for the course FIN 3310 taught by Professor Potts during the Fall '08 term at Baylor.

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Chapter 12 - Chapter 12 Business and Financial Risk In this...

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