Cost stability reflects the relative predictability

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Unformatted text preview: prices are, the lower the business risk; the less predictable and stable they are, the higher the business risk. Business risk varies among firms, regardless of their lines of business, and 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. Financial Risk The firm’s capital structure directly affects its financial risk, which is the risk to the firm of being unable to cover required financial obligations. The penalty for not meeting financial obligations is bankruptcy. The more fixed-cost financing—debt (including financial leases) and preferred stock—a firm has in its capital structure, the greater i...
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This document was uploaded on 03/30/2014.

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