Question

A firm’s capital structure is determined by more than just a component cost for each source of capital and is not fixed over time. Rather, the capital structure of a firm is determined by conditions in the domestic and international economies and it should also reflect changing conditions in the economy. In other words, the relationship between risk and return should be the major consideration in establishing the capital structure of the firm and the value of the firm.

Address all of the following questions in a brief but thorough manner.

What is the basic relationship between risk and return and how is this reflected in the value of the firm’s stock? The cost of debt?

What are the primary factors that should be considered when establishing a firm’s capital structure?

What are the primary differences and/or similarities between financial risk and business risk?

Answer 1

Risk and return are two opposing concepts in the financial world. Tradeoff between them will bring a financially healthy firm into existence. Generally, at low level of risk potential return tenda to be low as well. High level of risk are typically associated with high potential returns.

Weighted average cost of capital:-It is known as overall cost of capital of having capital from different sources. Thus WACC is the weighted average after tax cost of the individual components of firm's capital structure. If we are using more debt in capital structure, the risk will increase and finally WACC will also increase.Firm should generate minimum return of WACC to be financially viable. So the form should select an optimal capital structure that minimises WACC and hence maximises the wealth of shareholders and value of the firm as well.

WACC is used as the discount rate applied to future cash flows for deriving a business's net present value.

Factors should be considered while establishing firm's capital structure:

1. Cost principle:

According to this principle, an ideal pattern or capital structure is one that minimises cost of capital and maximises earnings per share.

2. Risk Principle:

Reliance is placed more on common equity for financing capital requirements than excessive use of debts. Use of more debt means higher commitment in the form of interest payout. This would leads to erosion to shareholders value. Two risks are

Business risk- unavoidable risk because of the environment in which firm is operating.

Finance risk- risk borne by shareholders when a firm uses debt in addition to equity financing.

3. Control principle

While designing the capital structure, the finance manager may also keep in mind that existing management control and ownership remains undisturbed.

4.Flexibility principle

Management uses such a combination of sources of financing which it find easier to adjust according to changes in need of future too.

5.Growth and stability of sales.

Capital structure of a firm is highly influenced by growth and stability of sales. If sale of firm are expected to remain fairly stable, it can raise higher level of debt. Stability of sale ensure that the firm will not face any difficulty in meeting fixed commitment of interest repayment of debt.

Business Risk and Financial Risk

Business Risk:

It is the unavoidable risk because of the environment in which firm has to operate and it is represented by the variability of earning before interest and tax (EBIT). The variability inturn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm's products .variations in prices and proportion of fixed cost in total cost.

Financial Risk:

It is the risk associated with availability of earnings per share caused by use of financial leverage. It is the additional risk borne by the shareholders when a firm uses debt in addition to equity financing.

Generally a firm should neither be exposed to high degree of business Risk and low degree of financial risk or vice-versa, so that shareholders do not bear a higher risk.