İŞLETME FİNANSI II

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.

WACC=EBIT/Firm value

WACC=300,000/(750,000+500,000)=0.24=24%

Value of the firm=EBIT/WACC

Value of the firm=500,000/0.16=$3,125,000

Value of equity=value of the firm- value of the debt = 3,125,000-1,200,000=$1,925,000

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 to arbitrage.

Signaling Theory:Within the assumption of perfect capital markets, symmetric information holds a significant stand, however, in real life, asymmetric information is observed. Investors do not have and cannot access the same information about the firm as its managers can. Thus, outside investors have a disadvantage in information gathering and this fact has a significant impact on the capital structure decisions. According to the signaling theory, managerial discretion may convey signals to outside investors other than the decisions on the surface.

Net Operating Income Approach: 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. Therefore, the firm value will remain unchanged by the financing decisions under the assumption of no corporate taxes.

Traditional Approach: A traditional approach is an intermediate model, compromising between the net income approach and the net operating income approach. Traditional approach assumes an optimal capital structure where the WACC is minimized and the value of the firm is maximized. The model suggests that up to a certain level of leverage, the use of debt financing reduces the WACC, but after that optimal level, the WACC escalates depressing the firm value.

As a broad definition, we can say that the debt and equity mix is called the capital structure of a firm. Because the capital structure determines the value of the firm, a target capital structure is tried to be maintained for shareholders’ wealth maximization, nevertheless, the actual portions of debt and equity financing alter over time. Assessing the target capital structure requires an appraisal of the financing sources, the evaluation of their risk, the examination of the maturity-cost relation of debt and the estimation of the cost of equity for different capital budget amounts. The correct answer is D.

Bankruptcy risk negatively affects the value of a firm. Firstly, 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 value of the firm declines as the bankruptcy risk rises since the free cash flows (FCF) drop with the loss of confidence in the firm. Another problem that is caused by the rising bankruptcy risk is the underinvestment in positive NPV projects. The correct answer is A.

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 B.

Firms raise equity funds from their shareholders, who own a direct share of the net income and the net worth of the company. As shareholders hold residual claims on both the earnings and the assets of the business, they bear more risk than the creditors. Therefore, equity financing becomes more expensive than debt financing. Furthermore, as more debt is raised, the risk borne by the shareholder’s increases, leading to a higher cost of equity. The correct answer is A.

The business risk is related to the uncertainty in the business operations of the firm. Business risk is influenced by numerous factors, including sales volume, per-unit price, input costs, competition, the overall economic conditions and etc. If not diversified, the stockholders bear both the business risk and the financial risk of the company. The correct answer is E.

The return on invested capital (ROIC) measures the operating profitability on capital investments:

ROIC=NOPAT/Capital=EBIT*(1-T)/Capital

NOPAT is the net operating profit after taxes and the capital is the amount of capital investment required for the persistence of the operations. The correct answer is B.

Maximizing the value of the firm is the main objective and the key to wealth maximization lies in the capital structure decisions. In an attempt to find the best practice in attaining this goal, academicians brought up a number of theoretical models:

The correct answer is D.

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 C.

Estimating the optimal capital structure requires a careful analysis with repetitions. The managers normally start with a trial capital structure and (4) evaluate shareholders’ wealth. They continue the same practice until they (2) identify a capital structure maximizing the firm value. At each trial, (1) the cost of debt and equity are projected in order to quantify the WACC. Then, (5) the forecasted free cash flows are capitalized at the calculated WACC to determine the firm value. As a final step, (3) debt is deducted from the value of the firm to measure the value of the equity and the stock price. In practice, we can utilize the earnings per share (EPS) analysis to determine the shareholders’ wealth:

The correct answer is E.

There are other factors that affect the capital structure. The political stability (economic environment-specific factors), the demand volatility (industry-specific factors), the legal status of the firm and the firm's level of leverage (firm-specific factors) are among these factors. The correct answer is A.