Income Stream Risks Business risk –Economy –Business cycle –Competition Operating risk Capital structure risk
Operating Risk The greater the fixed costs, the greater the risk. Why? Operating cost structure – ratio between fixed and variable costs. Does a manager have control over the operating cost structure?
Break-even Analysis Example: You are getting into the T-shirt business. Plain T-shirts cost you $9 each. You figure you can print your message on each shirt for a $1 each. You rent space for your shop for $200. You estimate you can sell the shirts, because you are oh-so clever, for $20 each. 1. What is your break-even units? 2. What is your break-even dollars?
Operating Leverage Amount of fixed costs vs. variable costs in revenue stream An indicator of risk Example: You are getting into the T-shirt business. Cloth costs you $5 for each T-shirt and you will make your own shirts. You figure you can print your message on each shirt for a $1 each. You rent space for your shop for $200 and a T-shirt making machine for $200. You estimate you can sell the shirts, because you are oh-so clever, for $20 each. 1. What is your break-even units? 2. What is your break-even dollars?
Firm Financing Financial structure –The right hand side of the balance sheet Capital structure –Stock and bond mix –Do not consider accounts payable and accrued expenses
Capital Structure Financial Leverage Use of fixed-income securities to fund firm activities –Bonds and preferred stock Magnifies the revenue effects on EPS and ROE Leverage – making money using other people’s money –What’s the downside?
Capital Structure Independence Hypothesis –Capital structure does not affect the cost of capital –Capital structure does not affect the firm’s value Moderate view –Accounts for the fact that interest is tax deductible –Considers that firm can default debt capacity –Debt capacity – max debt in capital structure that will still maintain lowest cost of capital
Capital Structure Practical Matters Want leverage ratio to be in a reasonable range –Too small, don’t take advantage of other people’s money, leverage –Too small, another firm may buy you with your own money –Too large, high risk –Target leverage ratio around 2 (=> debt ratio around.5) Coverage ratio –Shows if you can afford the risk –Use times interest earned = operating income / interest expense –Want > 2.5 For both ratios, look at industry averages Match borrowing maturity with asset term –Buy short-term assets with short-term liabilities –Buy long-term assets with long-term liabilities or equity