ch13 - CHAPTER13 CapitalStructureandLeverage...

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    13-1 CHAPTER 13 Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory
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    13-2 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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    13-3 What determines business risk? Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Operating leverage.
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    13-4 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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    13-5 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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    13-6 Using operating leverage Typical situation:  Can use operating leverage  to get higher E(EBIT), but risk also increases. Probability EBIT L Low operating leverage High operating leverage EBIT H
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    13-7 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.
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    13-8 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.
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    13-9 An example: Illustrating effects of financial leverage Two firms with the same operating leverage,  business risk, and probability distribution of  EBIT. Only differ with respect to their use of debt  (capital structure). Firm U   Firm L No debt   $10,000 of 12% debt $20,000 in assets   $20,000 in assets 40% tax rate   40% tax rate
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    13-10 Firm U: Unleveraged Economy Bad Avg. Good Prob. 0.25 0.50 0.25 EBIT $2,000 $3,000 $4,000 Interest 0 0 0 EBT $2,000 $3,000 $4,000 Taxes (40%) 800 1,200 1,600 NI $1,200 $1,800 $2,400
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    13-11 Firm L: Leveraged Economy Bad Avg. Good Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxes (40%) 320 720 1,120 NI $ 480 $1,080 $1,680 *Same as for Firm U.
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    13-12 Ratio comparison between  leveraged and unleveraged firms
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ch13 - CHAPTER13 CapitalStructureandLeverage...

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