Question

What are business risk and financial risk? How does each of them influence the firm’s capital structure decisions?

Answer 1

Business risk

Is uncertainity about the operating income,ie. EBIT dut to factors such as:

unpredictable demand for the company's products & hence sales

unpredictable cost of raw materials , labor, other utilities ,etc. &

all that go to make the EBIt, except interest on debt.

depends entirely on operational/business factors.

Whereas,

Financial risk

refers to the risk of cash flows not being sufficient to pay interest on the debt borrowed & repayment of debt on time.

Capital structure of a business is the proportion of debt or outside borrowings and the owners' funds, on the balance sheet of a company , as at a particular date.

Owners' funds include funds against common stock, preferred stock, retained earnings over the year after dividends

Both the above, describe the way how the assets & opeartions are finanaced.

The more the debt,the more the financial leverage --which has the advantage of increasing the value of the company with interest tax shields--ie. Cash(in the form of lesser tax cash outflow) retained with the company.

Effect on Capital structure decision:

As business risk is about operational uncertainties, it affects the creation or otherwise of the stockholders' networth , in the form of current year's net income.

whereas,

Financial risk will make the management to decide about the level of financial leverage , ie debt to be undertaken so as to finance mainly assets & sometimes operations(which are normally managed by trade-debts like supplier-credits). In a way. Financial risk , rebounds on common stock holders ,as some more business risk, as they have to bear the burden of interest on funds borrowed --- that needs to be paid even in the event of insolvency as a priority.

Thus , the assumption of these risks ,have their own effect on the capital structure decisions taken by a company & its shareholders.