ch 14 - Capital Structure and Leverage Chapter 14 Business...

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Unformatted text preview: Capital Structure and Leverage Chapter 14 Business vs. Financial Risk Optimal Capital Structure Operating Leverage Capital Structure Theory 14-1 What is business risk? Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Note that business risk does not include financing effects. Probability EBIT E(EBIT) Low risk High risk 14-2 What determines business risk? Uncertainty about demand (sales) Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage 14-3 What is operating leverage, and how does it affect a firms 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. 14-4 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 14-5 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 14-6 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. 14-7 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. 14-8 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). 14-9 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 Firm U: Unleveraged 14-10 Economy Bad Average Good Probability 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 Firm L: Leveraged 14-11 Economy Bad Average Good Probability* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800...
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This note was uploaded on 02/06/2012 for the course ECON 111 taught by Professor Risnit during the Spring '11 term at SUNY Suffolk.

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ch 14 - Capital Structure and Leverage Chapter 14 Business...

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