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361-CH13Concise - CHAPTER13 Businessvs.financialrisk...

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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 Target Capital Structure Preferred, Optimal mix of D, E and P/S to:  a) Max value of firm and b) Raise capital  and finance expansion Tradeoffs: More debt increases risk, which  lowers stock P; but more debt leads to  higher expected return on equity (ROE),  which raises stock P.  Optimal capital structure:  Max stock P .  
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13-3 4 Factors That Influence  Capital Structure 1. Business Risk – Risk w/no debt, 100% E 2. Firm’s tax position – Does it need more  tax shelter from debt or not? 3. Financial flexibility – Ability to raise  capital, on reasonable terms, under  adverse conditions 4. Managers: Conservative or aggressive?
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13-4 Uncertainty about future Operating Income (EBIT),  i.e., how well can we predict operating income? Note that business risk does not include financing  effects, of debt and interest expense for example. What is business risk? Probability EBIT E(EBIT) 0 Low risk High risk
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13-5 What determines business risk?   (Variability of EBIT) TR (Sales Revenue) = P x Q Uncertainty about demand (Sales): Q Uncertainty about output prices: P Uncertainty about costs (Input P) Elasticity of Demand – Price sensitivity Currency Risk Exposure – Foreign  sales? Product and other types of legal liability Operating leverage (FC vs. VC)
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13-6 Firms can control business risk: Negotiate long-term contracts for labor,  supplies, inputs, leases, etc. Marketing strategies to stabilize units sales  and prices Hedging with commodity and financial  futures to stabilize revenues and costs General Rule:  The greater the business  risk, the lower the optimal debt ratio. 
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13-7 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, and therefore do not  decline when demand falls, then the firm has  high operating leverage. Examples : Nuclear plant, UM-Flint, GM and  Ford, Automated Equipment vs. Low-Tech  Equipment General Rule : Higher the operating leverage,  the greater the business risk, lower optimal debt
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13-8 Effect of operating leverage More operating leverage leads to more  business risk, for then a small sales decline  causes a big profit decline.
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