Business risk varies among firms regardless of their

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Unformatted text preview: is not affected by capital structure decisions. The level of business risk must be taken as a “given.” The higher a firm’s business risk, the more cautious the firm must be in establishing its capital structure. Firms with high business risk therefore tend toward less highly leveraged capital structures, and firms with low business risk tend toward more highly leveraged capital structures. We will hold business risk constant throughout the discussions that follow. EXAMPLE Hint The cash flows to investors from bonds are less risky than the dividends from preferred stock, which are less risky than dividends from common stock. Only with bonds is the issuer contractually obligated to pay the scheduled interest, and the amounts due to bondholders and preferred stockholders are usually fixed. Therefore, the required return for bonds is generally lower than that for preferred stock, which is lower than that for common stock. Cooke Company, a soft drink manufacturer, is preparing to make a capi...
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