To further examine risk in the capital structure, two additional measures of risk found in capital budgeting:

1. Business Risk


A company's business risk is the risk of the firm's assets when no debt is used. Business risk is the risk inherent in the company's operations. As a result, there are many factors that can affect business risk: the more volatile these factors, the riskier the company. Some of those factors are as follows:
  • Sales risk - Sales risk is affected by demand for the company's product as well as the price per unit of the product.
  • Input-cost risk - Input-cost risk is the volatility of the inputs into a company's product as well as the company's ability to change pricing if input costs change.
As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.

2. Financial Risk
A company's financial risk, however, takes into account a company's leverage. If a company has a high amount of leverage, the financial risk to stockholders is high - meaning if a company cannot cover its debt and enters bankruptcy, the risk to stockholders not getting satisfied monetarily is high.

Let's use the troubled airline industry as an example. The average leverage for the industry is quite high (for some airlines, over 100%) given the issues the industry has faced over the past few years. Given the high leverage of the industry, there is extreme financial risk that one or more of the airlines will face an imminent bankruptcy.

Effect of Changes in Sales or Earnings on EBIT
Differing amounts of debt financing cause changes in EPS and thus a company's stock price. The calculations for EBIT and EPS are as follows:

Formula 11.16

EBIT = sales - variable costs - fixed costs
EPS = [(EBIT - interest)*(1-tax rate)] / shares outstanding
This LOS is best explained by the use of an example.

Example:
The following is Newco's cost of debt at various capital structures. Newco has $1 million in total assets and a tax rate of 40%. Assume that, at a debt level of zero, Newco has 20,000 shares outstanding.

Figure 11.10: Newco's cost of debt at various capital structures


 

In addition, Newco has annual sales of $5 million, variable costs are 40% of sales and fixed costs are equal to $2.4 million. At each level of debt, determine Newco's EPS.

Answer:
At debt level 0%:
Shares outstanding are 20,000 and interest costs are 0.
EPS = [($5,000,000 - 2,000,000 - 2,400,000-0)*(1-0.4)]/20,000
EPS = $18 per share

At debt level 20%:
Shares outstanding are 16,000 [20,000*(1-20%)] and interest costs are 8,000 (200,000*0.04).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-8,000)*(1-0.4)]/16,000
EPS = $22.20 per share

At debt level 40%:
Shares outstanding are 12,000 [20,000*(1-40%)] and interest costs are 24,000 (400,000*0.06).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-24,000)*(1-0.4)]/12,000
EPS = $28.80 per share

At debt level 60%:
Shares outstanding are 8,000 [20,000*(1-60%)] and interest costs are 48,000 (600,000*0.08).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-48,000)* (1-0.4)]/8,000
EPS= $41.40 per share

At debt level 80%:
Shares outstanding are 4,000 [20,000*(1-80%)] and interest costs are 80,000 (800,000*0.10).
EPS = [($5,000,000 - 2,000,000 - 2,400,000-80,000)* (1-0.4)]/4,000
EPS = $78.00 per share

With each increase in debt level (accompanied with the decrease in shares outstanding), Newco's earnings per share increases.



Operating Leverage and its Effects on a Project's Expected Rate of Return

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