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Unformatted text preview: Capital Structure Decisions: The Basics 16-1 a. Capital structure is the manner in which a firms assets are financed; that is, the right- hand side of the balance sheet. Capital structure is normally expressed as the percentage of each type of capital used by the firm--debt, preferred stock, and common equity. Business risk is the risk inherent in the operations of the firm, prior to the financing decision. Thus, business risk is the uncertainty inherent in a total risk sense, future operating income, or earnings before interest and taxes (EBIT). Business risk is caused by many factors. Two of the most important are sales variability and operating leverage. Financial risk is the risk added by the use of debt financing. Debt financing increases the variability of earnings before taxes (but after interest); thus, along with business risk, it contributes to the uncertainty of net income and earnings per share. Business risk plus financial risk equals total corporate risk. b. Operating leverage is the extent to which fixed costs are used in a firms operations. If a high percentage of a firms total costs are fixed costs, then the firm is said to have a high degree of operating leverage. Operating leverage is a measure of one element of business risk, but does not include the second major element, sales variability. Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in a firms capital structure. If a high percentage of a firms capital structure is in the form of debt and preferred stock, then the firm is said to have a high degree of financial leverage. The breakeven point is that level of unit sales at which costs equal revenues. Breakeven analysis may be performed with or without the inclusion of financial costs. If financial costs are not included, breakeven occurs when EBIT equals zero. If financial costs are included, breakeven occurs when EBT equals zero. c. Reserve borrowing capacity exists when a firm uses less debt under normal conditions than called for by the tradeoff theory. This allows the firm some flexibility to use debt in the future when additional capital is needed. 16-2 Business risk refers to the uncertainty inherent in projections of future ROE U . 16-3 Firms with relatively high nonfinancial fixed costs are said to have a high degree of operating leverage. 16-4 Operating leverage affects EBIT and, through EBIT, EPS. Financial leverage has no effect on EBIT--it only affects EPS, given EBIT. 16-5 If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges will also vary. Such a firm is said to have high business risk. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges, and interest payments are fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations....
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- Spring '10