LEVERAGE

provide the framework for financing decision of a firm.

involves the use of fixed cost to magnify returns.
results from the use of fixed-cost assets or funds to magnify returns to the
firm owners.

Operating Leverage is concerned with the relationship between firms sale revenue
and its earnings before interest taxes, or EBIT.

Financial Leverage is concerned with the relationship between firms EBIT and its
common stock earnings per share.

BUSINESS RISK
risk of the firms when no debt is used and the risk inherent in the companys
operation
which is the riskiness of the firms assets if no debt is used
is the single most important determinant of capital structure, and it
represents the amount of risk that is inherent in the firms operations even if it
uses no debt financing

FACTORS THAT AFFECT BUSINESS RISK

Business risk depends on a number of factors, including the following:
1. Competition. If a firm has a monopoly on a necessary product, it will have
little risk from competition and thus have stable sales and sales prices.
2. Demand variability. The more stable the demand for a firms products, other
things held constant, the lower its business risk.
3. Sales price variability. Firms whose products are sold in volatile markets are
exposed to more business risk than firms whose output prices a rest able, other
things held constant.
4. Input cost variability. Firms whose input costs are uncertain have higher
business risk.
5. Product obsolescence. Firms in high-tech industries like pharmaceuticals and
computers depend on a constant stream of new products. The faster its products
become obsolete, the greater a firms business risk.
6. Foreign risk exposure. Firms that generate a high percentage of their earnings
overseas are subject to earnings declines due to exchange rate fluctuations. They
are also exposed to political risk.
7. Regulatory risk and legal exposure. Firms that operate in highly regulated
industries such as financial services and utilities are subject to changes in the
regulatory environment which may have a profound effect on the companys current
and future profitability
8. The extent to which costs are fixed: operating leverage. If a high percentage of
its costs are fixed and thus do not decline when demand falls, this increases the
firms business risk. This factor is called operating leverage.
* the higher a firms operating leverage, the higher its business risk.

FINANCIAL RISK
which is the additional risk placed on the common stockholders as a result of
using debt.
an increase in stockholders risk, over and above the firms basic business
risk, resulting from the use of financial leverage.

Types of Financial Risk

Credit Risk - when one fails to fulfill their obligations towards their
counter parties.
Liquidity - arises out of inability to execute transactions
Asset
 Equity Risk
Foreign Investment Risk
Currency Risk

CAPITAL
refers to investor-supplied fundsdebt, preferred stock, common stock, and
retained earnings.
Investor-supplied funds such as long- and short-term loans from individuals
and institutions, preferred stock, common stock, and retained earnings.

A firms capital structure is typically defined as the percentage of each type of

investor-supplied capital, with the total being 100%. The mix of debt, preferred
stock, and common equity that is used to finance the firms assets. The optimal
capital structure is the mix of debt, preferred stock, and common equity that
maximizes the stocks intrinsic value. As we will see, the capital structure that
maximizes the intrinsic value also minimizes the WACC. The capital structure that
maximizes a stocks intrinsic value.

PROPOSITION I (without taxes)

Here is a partial listing of their assumptions:

1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firms future
investment opportunities.
6. EBIT is not affected by the use of debt.

PROPOSITION II (No taxes)

The greater percentage of debt in capital structure the greater rate of
return in

Capital Financial Distress is a condition where a company cannot meet, or has

difficulty paying off, its financial obligations to its creditors, typically due to
high fixed costs, illiquid assets or revenues sensitive to economic downturns.

Agency Cost
are a type of internal cost that arises from, or must be paid to, an agent
acting on behalf of a principal
These costs arise because of core problems, such as conflicts of interest,
between shareholders and management.
are internal costs incurred from asymmetric information or conflicts of
interest between principals and agents in an organization.

Types of Agency

Monitoring costs are incurred when the principals attempt to monitor or

restrict the actions of agents.
Bonding costs are incurred by the agent. Furthermore, an agent may commit to
contractual obligations that limit or restrict the agents activity.
Residual losses are the costs incurred from divergent principal and agent
interests despite the use of monitoring and bonding.