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11-Capital-structure-FIN6406 - Capital Structure n Business...

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Capital Structure  Capital Structure 11 Capital Structure n Business risk n Operating leverage and risk n Financial leverage and risk n Capital structure theory
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Capital Structure  Capital Structure 22 n Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? n 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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Capital Structure  Capital Structure 33 Factors That Influence Business Risk n Product, and other types of liability . n Uncertainty about demand for product (number of units sold) . n Uncertainty about output prices . n Uncertainty about input costs . n Degree of operating leverage (DOL) .
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Capital Structure  Capital Structure 44 What is operating leverage, and how does it affect a firm’s business risk? n Operating leverage is the use of fixed operating costs rather than variable costs, in product’s total cost. n If most operating costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage .
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Capital Structure  Capital Structure 55 n More operating leverage leads to more business risk. A small sales decline causes a big profit decline. Sales $ Revenue TC FC QB E Sales $ Revenue TC FC QB E Profit
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Capital Structure  Capital Structure 66 Probability EBIT L Low operating leverage
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