Chapter 14

Question 1

What is business risk?

Answer 1

• The riskiness inherent in the firm’s operations if it uses no debt
• A commonly used measure of business risk is ROIC

Question 2

What determines business risk?

Answer 2

• Competition
• Uncertainty about demand (sales)
• Uncertainty about output prices
• Uncertainty about costs
• Product obsolescence
• Foreign risk exposure
• Regulatory risk and legal exposure
• Operating leverage

Question 3

What is operating leverage and how does it affect a firm’s business risk?

Answer 3

• 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

Question 4

Effect of operating leverage

Answer 4

More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline

Question 5

Return on Invested Capital (ROIC)

Answer 5

• ROIC measures the after-tax return that the company provides for all its investors
• ROIC doesn’t vary with changes in capital structure

Question 6

What is financial leverage?

Answer 6

The use of debt and preferred stock

Question 7

What is financial risk?

Answer 7

The additional risk concentrated on common stockholders as a result of financial leverage

Question 8

Business Risk vs. Financial Risk

Answer 8

-Business risk depends on business factors such as competition, product obsolescence, and operating leverage

• Financial risk depends only on the types of securities issued:
  1. More debt, more financial risk
  2. Concentrates business risk on stockholders

Question 9

Optimal Capital Structure

Answer 9

• The capital structure (mix of debt, preferred, and common equity) at which P0 is maximized
• Trades off higher E(ROE) and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debt’s risk-related costs
• The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital

Question 10

Why do the bond rating and cost of debt depend upon the amount of debt borrowed?

Answer 10

As the firm borrows more money, the firm increases its financial risk causing the firm’s bond rating to decrease and its cost of debt to increase

Question 11

Sequence of Events in a Recapitalization

Answer 11

1. Firm announces the recapitalization
2. New debt is issued
3. Proceeds are used to repurchase stock:
   - The number of shares repurchased is equal to the amount of debt issued divided by price per share

Question 12

What effect does more debt have on a firm’s cost of equity?

Answer 12

• If the level of debt increases, the firm’s risk increases
• We have already observed the increase in the cost of debt
• However, the risk of the firm’s equity also increases, resulting in a higher rs

Question 13

Hamada Equation

Answer 13

• Because the increased use of debt causes both the costs of debt and equity to increase, we need to estimate the new cost of equity
• The Hamada equation attempts to quantify the increased cost of equity due to financial leverage
• Uses the firm’s unlevered beta, which represents the firm’s business risk as if it had no debt.

Question 14

Finding Optimal Capital Structure

Answer 14

• Minimizes WACC
• Maximizes stock price

***Both methods yield the same results

Question 15

What if there were more business risk than originally estimated, how would the analysis be affected?

Answer 15

If there were higher business risk, then the probability of financial distress would be greater at any debt level, and the optimal capital structure would be one that had less debt

Question 16

What if there were less business risk than originally estimated, how would the analysis be affected?

Answer 16

However, lower business risk would lead to an optimal capital structure with more debt

Question 17

MM Irrelevance Theory

Answer 17

• The graph shows MM’s tax benefit vs. bankruptcy cost theory
• Logical, but doesn’t tell whole capital structure story
• Main problem: assumes investors have same information as managers`

Question 18

Incorporating Signaling Effects

Answer 18

• Signaling theory suggests firms should use less debt than MM suggest
• This unused debt capacity helps avoid stock sales, which depress stock price because of signaling effects

Question 19

What are “signaling” effects in capital structure? Assumptions?

Answer 19

• Managers have better information about a firm’s long-run value than outside investors
• Managers act in the best interests of current stockholders

Question 20

What are “signaling” effects in capital structure? What can managers be expected to do?

Answer 20

• Issue stock if they think stock is overvalued
• Issue debt if they think stock is undervalued
• As a result, investors view a stock offering negatively; managers think stock is overvalued

Question 21

Conclusions on Capital Structure

Answer 21

• Need to make calculations as we did, but should also recognize inputs are “guesstimates”
• As a result of imprecise numbers, capital structure decisions have a large judgmental content
• We end up with capital structures varying widely among firms, even similar firms in same industry