361-CH13Concise - 13-1CHAPTER 13Capital Structure and...

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Unformatted text preview: 13-1CHAPTER 13Capital Structure and LeverageBusiness vs. financial riskOptimal capital structureOperating leverageCapital structure theory13-2Target Capital StructurePreferred, Optimal mix of D, E and P/S to: a) Max value of firm and b) Raise capital and finance expansionTradeoffs: 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. 13-34 Factors That Influence Capital Structure1. Business Risk – Risk w/no debt, 100% E2. 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 conditions4. Managers: Conservative or aggressive?13-4Uncertainty 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?ProbabilityEBITE(EBIT)Low riskHigh risk13-5What determines business risk? (Variability of EBIT)TR (Sales Revenue) = P x QUncertainty about demand (Sales): QUncertainty about output prices: PUncertainty about costs (Input P)Elasticity of Demand – Price sensitivityCurrency Risk Exposure – Foreign sales?Product and other types of legal liabilityOperating leverage (FC vs. VC)13-6Firms can control business risk:Negotiate long-term contracts for labor, supplies, inputs, leases, etc.Marketing strategies to stabilize units sales and pricesHedging with commodity and financial futures to stabilize revenues and costsGeneral Rule: The greater the business risk, the lower the optimal debt ratio. 13-7What 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 EquipmentGeneral Rule: Higher the operating leverage, the greater the business risk, lower optimal debt13-8Effect of operating leverageMore operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.What happens if variable costs change?...
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361-CH13Concise - 13-1CHAPTER 13Capital Structure and...

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