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CHAPTER 13
Capital Structure and Leverage
Business vs. financial risk Optimal capital structure Operating leverage
Capital structure theory
131
What is business risk?
Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?
Probability Low risk
High risk
0 E(EBIT) EBIT
Note that business risk does not include financing effects.
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What determines business risk?
Uncertainty about demand (sales).
Uncertainty about
Uncertainty about
output prices.
costs.
Product, other types of liability. Operating leverage.
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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.
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Effect of operating leverage
More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
$ Rev. $ TC
FC
Rev.
} Profit TC
FC
QBE Sales QBE Sales
What happens if variable costs change? 135
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