Chapter 15 Mini Case

Using the free cash flow valuation model, show the only avenues by which capital structure can affect the value

What is business risk? What factors influence a firm’s business risk?

Business risk is the risk that businesses will not meet their profit objectives and capital requirements without debt (Bringham & Ehrhardt, 2020). Many businesses exist to generate profits for common stockholders. However, unforeseen internal and external factors may cause the business to experience challenges. They include changes in consumer tastes and preferences, high competition, or government policy and regulation changes. Internal factors include fixed costs and variables. If a business has a high level of fixed costs that do not decline to commensurate with a decline in revenues, the organization has high operating leverage; this increases business risk. The key indicators for business risk are Earnings Before Interest and Tax (EBIT), Net Operating Profit After Tax (NOPAT), and Return on Invested Capital (ROIC)

What is operating leverage, and how does it affect a firm’s business risk? Show the operating breakeven point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.

Operating leverage measures an organization’s operating income with respect to revenue (Bringham & Ehrhardt, 2020). When organizations generate revenues, some income goes towards the settlement of fixed and variable costs and expenses. High operating leverage shows that a small change in revenues can significantly change net income due to high fixed costs increasing business risk.

A good example would be in the capital, labor, or technology-intensive industry, where these operations have to be maintained regardless of the changes in sales. Low operating leverage means that there would need to be a significant change in sales to affect net income and hence a low operating risk (Novy-Marx, 2010).

Operating breakeven is achieved when revenues, fixed costs, and variable costs per unit equal zero. Therefore, the breakeven would be computed as follows, assuming the operating breakeven sales are x units.

Sales revenue $15x

Less

Fixed costs $200

Variable cost 10x

EBIT 0

Computation

15x-200-10x=0, therefore, 5x-200=0 and 5x=200.

The operational breakeven is 40 units. This means that the company has to sell at least 40 units to meet fixed and variable costs.

The difference between financial and business risk

Business risk is the risk that an organization’s shareholders face due to uncertainty in the absence of debt. It is the risk that the organization will not meet its profitability and capital structure requirements (Chen et al., 2018). On the other hand, finance risk is the additional risk faced by common stockholders when a firm uses financial leverage to finance operations. When an organization is financed fully through equity, the shareholders are paid their dividends according to what they own. In case the organization is financed partly through debt, it means that common stockholders take priority over common stockholders (Alder & Triantis, 2017). During disbursement of profits and in case of liquidation, debt holders are paid before common stockholders meaning that common stockholders bear the majority of the risk.

References

Adler, B. E., & Triantis, G. (2017). Debt Priority and Options in Bankruptcy: A Policy Intervention. Am. Bankr. LJ, 91, 563. https://heinonline.org/HOL/LandingPage?handle=hein.journals/ambank91&div=24&id=&page=

Brigham, E. F., & Ehrhardt, M. C. (2020). Financial management: Theory and practice [with MindTap] (16th ed.). Mason, OH: South-Western. ISBN-13: 9781337902601.

Chen, Z., Harford, J., & Kamara, A. (2018). Operating Leverage, Profitability, and Capital Structure. Journal of Financial and Quantitative Analysis, 54(1), 369–392. https://doi.org/10.1017/s0022109018000595

Novy-Marx, R. (2010). Operating Leverage*. Review of Finance, 15(1), 103–134. https://doi.org/10.1093/rof/rfq019