İŞLETME FİNANSI II

The value of the firm is measured as the sum of the value of the firm’s equity and the value of the debt.

There are many factors affecting the business risk of a firm, however, to summarize we can cite the following:
• Shifts in the demand for the products/ services of the company. Higher volatility of demand for the products/services of the firm escalates the business risk.
• Fluctuations in the sales price due to market volatility. Firms operating in markets with high output price variations are prone to higher business risk.
• Changes in input costs. Uncertainty and excessive volatility in input costs raise the business risk.

• The cost structure of the company, especially the level of the fixed costs in total costs which are measured by the degree of operating leverage (DOL). If the DOL
is high, the firm will be exposed to higher business risk.
• The ability to adapt cost-effective measures to changes in both the input costs and output prices. Some firms can quickly implement cost-effective processes to adjust
to the fluctuations in input costs or output prices. This ability reduces the business risk faced by the company.

Financial leverage is an indicator of financial risk and occurs in case of borrowing

The net income approach advocates that a firm can boost its value by lowering its WACC, which is possible by increasing financial leverage in its capital structure. In this approach, it is assumed that the cost of debt is always less than the cost of equity and that the increase in the debt ratio does not lead to a change in the risk perception of the investors.

Franco Modigliani and Merton Miller (MM) are the founders of modern capital structure theory. Their first article (1958) is one of the most influential studies in academia. MM’s study is based on the following assumptions:
1. Capital markets are perfect with rational investors that can freely buy and sell assets.
2. Investors have homogenous expectations.
3. There are no bankruptcy costs.
4. There are no taxes.
5. There are no transaction costs in financial asset trading.
6. Investors and companies can borrow at the same rate with no restrictions.
7. All investors can access the same information as the managers of a company without paying any information cost.
8. Operating income (EBIT) is not affected by the use of debt.
9. All earnings are distributed to stockholders as dividends (dividend payout ratio is 100%).
10. Well-informed investors have the option of arbitrage.

Not only bankruptcy, but the possibility of financial distress can also create problems leading to higher interest rates, contractions in credit purchases, employee jump ship and loss of customers. Therefore, financial distress or bankruptcy costs refrain firms from abundant debt financing. Especially firms with higher business risk should rely less on debt financing.

Asymmetric information occurs when one party from a financial transaction has different information than the other.

Agency theory suggests that agency problems may arise if managers (agents) pursue different objectives other than those of the shareholders (principals). Shareholders seek for wealth maximization which can be attained by the maximization of the value of the firm. However, managers often waste shareholders’ wealth by consuming perquisites or
investing in pet projects

Other factors that affect the capital structure are industry-specific factors, environment-specific factors, and firm-specific factors.

Bankruptcy risk refers to the likelihood that a company will be unable to meet its debt obligations. The correct answer is E.

The value of the firm is measured as the sum of the value of the firm’s equity and the value of the debt. The correct answer is E.

Bankruptcy risk negatively affects the value of a firm. Firstly, as mentioned above the before-tax cost of debt increases which makes debt financing more costly. Secondly, the stockholders who hold residual claims in sharing the earnings and assets of the company demand a higher yield. Since creditors have a priority in their claims, higher debt ratios and the rising probability of bankruptcy heighten the risk borne by the stockholders. As a result, the cost of the funds raised by the company, no matter debt or equity upsurge, raises the weighted average cost of capital (WACC). The WACC is the average cost of the capital mix. 

The correct answer is D.

There are many factors affecting the business risk of a firm, however, to summarize we can cite the following:

• Shifts in the demand for the products/ services of the company. Higher volatility of demand for the products/services of the firm escalates the business risk. • Fluctuations in thesales price dueto market volatility. Firms operating in markets with high output price variations are prone to higher business risk.

• Changes in input costs. Uncertainty and excessive volatility in input costs raise the business risk.

• The cost structure of the company, especially the level of the fixed costs in total costs which are measured by the degreeof-operating leverage (DOL). If the DOL is high, the firm will be exposed to higher business risk.

• The ability to adapt cost-effective measures to changes in both the input costs and output prices. Some firms can quickly implement cost-effective processes to adjust to the fluctuations in input costs or output prices. This ability reduces the business risk faced by the company. The correct answer is E.

Financial risk is the additional risk borne by the stockholders when the company raises debt financing. The correct answer is C.

Other than the economy-wide and industry-specific factors, firm characteristics are also highly influential in capital structure decisions. Each firm has unique features affecting its asset structure, risk appetite, and competitive strength. The firm age, size, and its legal status are among other elements that impact capital structure. Additionally, the performance of the company, its short and long-term solvency, its level of leverage determines its creditworthiness. Credit-worthy businesses can have easy access to available funds both in debt and equity. Thus, they will enjoy more flexibility in capital structure decisions. 

The correct answer is C.

Economic Environment

The economic conditions in general impact the investment and financing decisions simultaneously. The economic policies of the country where the company is established to determine the market conditions shaping up both the forces of demand and supply. The political and economic stability affect the level of risk at the macro and micro levels. The inflation rate leads to the interest rate. Furthermore, the tax rates directly impel the level of investments and financing mechanisms. Risk escalates in an economic environment with high inflation and interest rates. Thus both debt and equity become more expensive and scarce. In such an environment businesses are hesitant in making new investments. Additionally, foreign exchange rates influence overseas investments and trading. Overseas transactions may bring some benefits and disadvantages at the same time. Companies may increase their income, however, investments abroad raise the risk undertaken.

The correct answer is B.

The net income approach advocates that a firm can boost its value by lowering its WACC, which is possible by increasing financial leverage in its capital structure. In this approach, it is assumed that the cost of debt is always less than the cost of equity and that the increase in the debt ratio does not lead to a change in the risk perception of the investors. The correct answer is B.

The model assumes that the cost of debt, the WACC and the value of the firm is irrespective of financial leverage. The value of the firm is its net operating income which is also independent of leverage, capitalized at the constant WACC. The correct answer is A.

According to the signaling theory, managerial discretion may convey signals to outside investors other than the decisions on the surface. The correct answer is A.

Bankruptcy risk refers to the likelihood that a company will be unable to meet its debt obligations.