Question

Assume that you have just been hired by Adams, Garitty, and Evans (AGE), a consulting firm that specializes in analyses of firms’ capital structures. Your boss has asked you to examine the capital structure of Campus Deli and Sub Shop (CDSS), which is licates 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 enrollmenr is capped, EBIT is expected to be comstant over time. Because no expansion capital is required, CDSS pays out all earnings as dividends. The management group owns 50% of the stick, which is traded in the over-the-counter market.

CDSS 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 CDSS’s shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encourages 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

1000. 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 askingnand then answering the following questions:

a. (1) What is business risk? What factors infleuence 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?

Answer 1

EBIT = 500,000 and it will be constant over time.

PAT = 500,000( 1- 0.40)

= 300,000

As there are no fixed financial cost PAT is the earnings available to the shareholders.So 300,000 available to shareholders if there is no debt.

EPS = 300,000 \ 100,000 = $3

Market price is $20  

AT $250,000 debt k_d =10.0%

PBT = EBIT - interest

= 500,000 - 25,000

= 475,000

PAT = PBT(1- Tax rate)

475,000(1-0.4)

= 285,000

EPS = 285,000 \ 100,000 = $2.85

Market price = 2.85 \ 0.155

= 18.387

AT 500,000 DEBT @11%

PBT = 500,000 - 55,000

= 445,000

PAT = 445,000( 1- 0.40)

= 267,000

EPS = $2.67

MARKET PRICE OF SHARES = 2.67 \ 0.165

= 16.182

AT 750,000 DEBT @ 13%

PBT = EBIT - INTEREST

= 500,000 - 97,500

= 402,500

PAT = PBT ( 1- TAX RATE )

= 402500( 1- 0.4)

= 241,500

EPS = $ 2.415

MARKET PRICE OF SHARE = 2.415 \ 0.18

= 13.42

AT 1,000,000 DEBT @ 16%

PBT = 500,000 - 160,000

= 340,000

PAT = PBT ( 1- TAX RATE )

= 340,000 ( 1- 0.40)

= 204,000

EPS = 2.04

MARKET PRICE OF SHARE = 2.04 \ 0.20

= 10.2

USE OF DEBT IN CAPITAL STRUCTURE OF COMPANY CAN INCREASE FIRM' S VALUE BUT IT ALSO INCREASES THE COST OF EQUITY WHICH RESULTS IN DECREASE IN MARKET PRICE OF SHARES.

A) BUSINESS RISK - Business risk of a firm exist because of its investment decision.Business risk is the firm specific risk and its diversified . It arises due to the presence of  fixed operating costs in the cost structure of the company. Fixed operating costs magnify the effects of change in sales on operating profits.

following are some factors affecting business risk of a company

1. changes  in sales

2. Change in consumer demand as it can decrease or increase sales and prices of products

3.Changes in overall economy as volatile economic conditions increase business risk

4. Market competition greater the competition greater is business risk

5.Government regulations on sales of a product or lenient conditions for sale  

6.Changes in per unit cost and selling price

7.Size of the business - Smaller the business higher the business risk .

8. Rapid changes in technology - Business risk is higher in company dependent on technology

9. Single product company is more prone to higher business risk then a company having diversified product portfolio.

2) Operating leverage - Operating leverage arises due to the fixed operating costs. Higher the composition of fixed costs in the operating activities of the business higher will be it operating leverage.If with decrease in the demand fixed costs don't decrease firm is said to have higher operating leverage.Generally higher the business's operating leverage higher the business risk. Degree of operating leverage can be calculated to find out the business risk

DEGREE OF OPERATING LEVERAGE = % change in EBIT \ % change in sales

Business risk arises when degree of operating leverage becomes greater than 1.

3) Financial leverage occured when firm chooses to include debt \ preference stock in its capital structure.Financial leverage because of fixed financial cost in in its income statement. As fixed financial costs are to be paid without any consideration to to the income of the company as interests on debt.It is measured with the help of DEGREE OF FINANCIAL LEVERAGE .

DEGREE OF FINANCIAL LEVERAGE = % changes in EPS \ % changes in EBIT.

When degree of financial leverage becomes greater then 1 financial  risk of the firm increases.

FINANCIAL RISK is the risk over and above the business risk of the company . It exists when firm decided to finance with debt. its borne by shareholders.Is the risk of the business defaulting on its fixed payment obligations.

2) Business risk is affected by many factors but Financial risk is influenced by the presence and level of debt in the capital structure of the firm.

Business risk is inherited in the business activities as obsolescence of machinery but financial risk is opted by the choice of management.