Assume that you have just been hired by XYZ, a consulting firm that specializes
ID: 2802988 • Letter: A
Question
Assume that you have just been hired by XYZ, a consulting firm that specializes in analyses of firms’ capital structures. Your boss has asked you to examine the capital structure of Sunshine Deli and Sub Shop (SDSS), which is located adjacent to the campus. According to the owner, sales were $1,350,000 last year, variable costs were 60% of sales, and fixed costs were $40,000. As a result, EBIT totaled $500,000. Because the university’s enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, SDSS pays out all earnings as dividends. The management group owns 50% of the stock, which is traded in the over-the-counter market.
SDSS currently has no debt—it is an all equity firm—and its 100,000 shares outstanding sell at a price of $20 per share. The firm’s marginal tax rate is 40%. On the basis of statements made in your finance class, you believe that SDSS’s shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea, but to provide support for the suggestion.
You then obtained from a local investment banker the following estimates of the costs of debt and equity at different debt levels (in thousands of dollars) Amount Borrowed rd rs
$ 0 —- 15.0%
250 10.0% 15.5
500 11.0 16.5
750 13.0 18.0
1,000 16.0 20.0
If the firm were recapitalized, debt would be issued, and the borrowed funds would be used to repurchase stock. You plan to complete your report by asking and then answering the following questions:
a. (1) What is business risk? What factors influence a firm’s business risk?
(2) What is operating leverage, and how does it affect a firm’s business risk?
b. (1) What is meant by the terms financial leverage and financial risk?
(2) How does financial risk differ from business risk?
c. Now, develop an example that can be presented to SDSS’s management. As an illustration, consider two hypothetical firms, Firm U, with zero debt financing, and Firm L, with $10,000 of 12% debt. Both firms have $20,000 in total assets and a 40% marginal tax rate, and they face the following EBIT probability distribution for next year:
Probability EBIT
0.25 $2,000
0.50 3,000
0.25 4,000
Explanation / Answer
A(1) Business risk refers to the basic viability of a business, the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. Business risk is the possibility a company will have lower than anticipated profits or experience a loss rather than taking a profit. Business risk is influenced by numerous factors, including sales volume, per-unit price, input costs, competition, the overall economic climate and government regulations. factors influence a firm’s business risk: 1. Intensity of Competition-The higher the level of competition, the higher the business risk 2. Higher Fixed Cost Structure-Generally, if a business has higher fixed costs it will result in higher business risk. If the business’s cost structure comprises mainly variable costs, it has a much lower business risk than one that has fixed costs 3. Size of business-The smaller the firm, the higher the business risk as it is more difficult for a small firm which is usually a new firm to compete or be more adaptable compared to a bigger or established firm. 4. Growth prospect:-Rapid growth/expansion would expose the firm to higher business risk as it can cause earnings to be more volatile 5. Product diversification-the more a firm is dependent on one product, the higher the business risk compared to a firm which has a few products hence its performance does not depend on only one product and is able to reduce risk. 6. Sensitivity of demand for a firm’s products to general economic conditions- if the demand for a firm’s product is highly sensitive to economic conditions, the higher is the business risk. A firm that sell essential goods has a low business risk as the demand for their products is generally stable irrespective of economic conditions. A(2) Operating leverage is a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. A business that makes sales providing a very high gross margin and fewer fixed costs and variable costs has much leverage. Operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky, or volatile, a company's operating income is. companies assess their business risk by capturing a variety of factors that may result in lower-than-anticipated profits or losses. One of the most important factors that affect a company's business risk is operating leverage; it occurs when a company must incur fixed costs during the production of its goods and services. A higher proportion of fixed costs in the production process means that the operating leverage is higher and the company has more business risk. B(1) Financial leverage can be defined as the degree to which a company uses fixed-income securities, such as debt and preferred equity. With a high degree of financial leverage come high interest payments. financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company. B(2) The following are the major differences between business risk and financial risk: 1. The uncertainty caused due to insufficient profits in the business due to which the firm is not able to pay out expenses in time is known as Business Risk. Financial Risk is the risk originating due to the use of debt funds by the entity. 2. Business Risk can be evaluated by fluctuations in Earning Before Interest and Tax. On the other hand, Financial Risk can be checked with the help of leverage multiplier and Debt to Asset Ratio. 3. Business Risk is linked with the economic environment of business. Conversely, Financial Risk associated with the use of debt financing. 4. Business Risk cannot be reduced while Financial Risk can be avoided if the debt capital is not used at all. 5. Business Risk can be disclosed by the difference in net operating income and net cash flows. In contrast to Financial Risk, which can be disclosed by the difference in the return of equity shareholders.