Lecture Fundamentals of financial management - Chapter 13: Capital structure and leverage. This chapter presents the following content: Business vs. financial risk, optimal capital structure, operating leverage, capital structure theory. | CHAPTER 13 Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory Uncertainty about future operating income (EBIT), ., how well can we predict operating income? Note that business risk does not include financing effects. What is business risk? Probability EBIT E(EBIT) 0 Low risk High risk What determines business risk? Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Operating leverage. 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, hence do not decline when demand falls, then the firm has high operating leverage. 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 QBE Sales $ Rev. TC FC QBE } Profit Using operating leverage Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases. Probability EBITL Low operating leverage High operating leverage EBITH 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. 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. 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). Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets . | CHAPTER 13 Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory Uncertainty about future operating income (EBIT), ., how well can we predict operating income? Note that business risk does not include financing effects. What is business risk? Probability EBIT E(EBIT) 0 Low risk High risk What determines business risk? Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Operating leverage. 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, hence do not decline when demand falls, then the firm has high operating leverage. 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 .
