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33 Cards in this Set
- Front
- Back
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What is Business Risk? |
The risk inherent in the firm's operations, which arises from uncertainty about future operating profits and capital requirements. |
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Volatility/Variability in product demand |
General motors has more demand variability than kroger because when people come across hard times financially they stop buying cars but still afford to buy food |
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Slow entry with new products into the market |
Being faster to the market allows companies to more quickly respond to changes in consumer desires |
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International operations |
add the risk of currency fluctuations and political risk |
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High Operating Leverage |
When a high percentage of firm's costs are fixed and hence does not decline when demand falls, the firm has high operating leverage, which increases its business risk |
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A change in sales affects |
EBIT |
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Degree of Operating Leverage (DOL) |
= % change EBIT / % Change sales |
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Operating Leverage |
Involves using a large proportion of fixed costs to variable cost in the operations of the firm. The higher the degree of operating leverage, the more volatile the EBIT figure will be relative to a given change in sales, all other things remaining the same. |
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What is financial risk? |
the additional risk placed on the common stockholders as a result of the decision to finance with debt. Volatility of Net Income No debt, no financial risk |
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Degree of Financial Leverage (DFL) |
= % change in Net Income / % change in EBIT Measures the percentage change in earnings per share (EPS) for a unit change in earnings before interest and taxes (EBIT) |
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Degree of Financial Leverage Ratio |
Shows that the higher the degree of financial leverage, the more volatile is EPS. Since interest is a fixed expense, leverage magnifies returns and EPS, which is good when operating income is rising, but it can be a problem during tough economic times when operating income is under pressure |
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Degree of Total Leverage (DTL) |
By combining the degree of operating leverage with the degree of financial leverage we obtain the degree of total leverage (DTL). If a firm has a high amount of operating leverage and financial leverage, a small change in sales will lead to a large variability in EPS. |
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Degree of Total Leverage (DTL) equation |
= % change in EPS or NI / % change in sales = 1.0 if no fixed cost and no debt = DOL x DFL |
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Pros and Cons of Debt Financing |
Debt financing increases EPS, and financial risk. |
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How does debt financing affect stock price |
Maximization of stock price |
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NPV |
the present value of a projects cash inflows minus the present value of its cost, tells us how much the projects contributes to shareholders wealth. Larger the NPV the better it is. |
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IRR |
discount rate that forces the PV of the inflows to equal the initial cost. The IRR is an estimate of the projects rate of return, and it is comparable to the yield to maturity on a bond. |
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Conflict between NPV and IRR |
When conflicts occur the NPV criteria is generally better. The higher the NPV the better. |
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NPV profiles |
Timing differences and Project size differences. |
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Timing differences |
If most cash flows from one project come in early while most of those from the other project come in later, then the NPV profiles may cross and result in a conflict |
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Project size differences |
If the amount invested in one project is larger than the other, this can also lead to profiles crossing and result in conflict |
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Taxation of Salvage |
If CPC terminates operations before the equipment if fully depreciated. The after tax salvage value depends on the price at which GPC can sell the equipment and on the book value of the equipment |
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Equivalent annual annuity (EAA) |
Converting annual cash flows under alternative investments into a constant cash flow stream whose NPV was equal to the NPV of the initial stream. |
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The unequal life issue |
does not arise from independent projects but can arise if mutually exclusive project with significantly different lives are being compared |
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Debt financing |
High levels of debt bond the cash flow, since much of its precommited to servicing the debt. If managers have excess cash flow they can make dumb decisions. Debt financing increases both returns and financial risk. |
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Positive financial leverage |
Assets acquired with the funds provided by creditors and preferred stockholders generate a rate of return that is higher than the rate of interest of dividend payable to the providers of funds. It is beneficial for common stockholders Debt goes up EPS goes up |
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Negative Financial Leverage |
Occurs when the assets acquired with the debts and preferred stock generate a rate of return that is less than the rate of interest or dividend payable to the providers of debts or preferred stock. This is a loss for common stockholders. Debt goes up EPS goes down |
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Optima capital structure |
seeks to maximize the price of the firms stock |
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Objective of dividend policy |
how much to retain for reinvestment, need retained earnings for growth. How much to pay out to shareholders. return all earnings now or larger returns later. Optimal dividends to max stock price |
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Dividend irrelevance theory |
holds that a firms dividend policy has no effect on either the value of its stock or its capital |
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Bird in the hand Theory |
holds that the firm's value will be maximized by a high dividend payout ratio, because investors regard cash dividends as being less risk then potential capital gains |
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Tax differential Theory |
States that because long term capital gains are subject to lower taxes than dividends, investors prefer to have companies retain earnings rather than pay them out as dividends. |
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Signaling Theory |
Larger than expected dividend signals improving future earnings. Dividend reduction signals poor future earnings |
