Two elements of risk are primary considerations in the capital structure decision: the business risk and the financial risk of a firm. Financial risk is discussed in the following section.
Business risk refers to the variability or uncertainty of a firm’s operating income (EBIT). Many factors influence a firm’s business risk (holding constant the effects of all other important factors), including
The DOL is defined as the percentage change in EBIT resulting from (divided by) a given percentage change in sales (output).Thus, if a firm is subject to considerable sales volatility over the business cycle, the variability of EBIT (business risk) can be reduced by limiting the use of assets having fixed costs in the production process. Similarly, if a firm’s sales tend to be stable over the business cycle, using a high percentage of fixed -cost assets in the production process will have little impact on the variability of EBIT.
In a sense, the business risk of a firm is determined by the accumulated investments the firm makes over time. These investments determine the industries in which a firm will compete, the amount of market power the firm will possess, and the extent of fixed costs in the production process.
Firms in consumer products industries, such as grocery retailing (Albertsons, for example), brewing (Anheuser -Busch), food processing (Kraft Foods), and electric (Duke Energy) and natural gas distribution (Piedmont Natural Gas) utilities, tend to have low levels of business risk. In contrast, firms in durable goods manufacturing (DaimlerChrysler), industrial goods manufacturing (USX-US Steel), and airlines (Delta Air Lines) tend to have higher levels of business risk.
Business Risk: Systematic or Unsystematic Risk?
Business risk possesses elements of both systematic risk and unsystematic risk. Some of the variability in operating income that results from business risk cannot be diversified away by investors who hold a broad -based portfolio of securities. For example variability attributable to business cycle behavior is clearly systematic. In contrast, the variability attributable to specific managerial decisions, such as product line diversity, is primarily unsystematic. When analysts attempt to assess the specific total risk of a firm, they must consider both systematic and unsystematic components of that risk.
A firm may encounter operating (and financial) difficulty because of both economy -wide factors that impact its operations and because of unique decisions made by its management.
Financial Management Related Interview Questions
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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