Risks in Capital Structure:
- Business risk:
Business risk is the risk inherent in the operation of the firm, prior to the financing decision. Thus, business risk is the uncertainty inherent in a total risk sense, future operating income, or Earnings Before Interest and Taxes (EBIT). Business risk is caused by many factors. Two of the most important are sales variability and operating leverage.
- Uncertainty about future operating income.
- Note that the business rise firm's focuses on the operating income, so it ignores financing effects.
Factors that influence Business Risk:
- Uncertainty about demand (unit sales).
- Uncertainty about output prices.
- Uncertainty about input costs.
- Product and other type of liability.
- Degree of operating leverage. (DOL)
How would higher or lower business risk affect the optimal capital structure?
- At any debt level, the firm's probability of financial distress would be higher.
Both cost of debt and cost of equity would rise faster than before. The end result would be an optimal capital structure with less debt.
- Lower business risk would have the opposite effect.
Financial risk:
Financial risk is the risk added by the use of debt financing, Debt financing increases the variability of earning before taxes (but after interest) ; thus, along with business risk, it contributes to the uncertainty of net income and earnings per share. Business risk financial risk equals total corporate risk.
Business vs. Financial Risk:
- Even under no debt =variability (EBIT changes and so des ROE)
- So a company with great deal of the business risk would not want a lot of debt because it would accentuate that variability even more.
- A company with low business risk would be able to handle more debt.
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