Business and Financial Environment - Essay Example

Business and Financial Environment Executive Summary Organizations, when operate, face different type of risks. If the organization is financed all through equity, then stockholders will face the risk inherent in the operations of that business which is called the Business Risk. Business risk is influenced by many factors which include Demand Variability, Price Stability, Input Cost Variability, Adaptability of output prices with the changes in input prices, Ability to develop new products and Degree of Operating Leverage. A firm incorporates operating leverage in its operation when it invests more into fixed assets. A Firm exposes itself to financial risk with the introduction of debt in its capital structure. When the organization raises debts, the risk will concentrate to stockholders and they will ask for higher return to bear that risk. As the company includes more and more debt to its capital structure the rate of Return required by the company increases. WACC which comprises of weighted average of cost of Debt and cost of Equity increases as the firm is exposed to more and more debt. The increase in debt increases the risk of the company and as the debt to equity ratio in a capital structure of the firm increases the Return on Equity required by the firm increases which increases the WACC for the firm. This will also increase the amount of earnings required by the firm to keep its value to its previous position. Table of Content (i) Business Risk..3 (ii) Operating Leverage.4 (iii) Financial Risk..4 (iv) II (a).5 (v) II (b).6 (vi) III (a)....7 (vii) III (b)....7 (viii) IV..8 Assumptions for MM Propositions.8 MM Proposition (I).8 MM Proposition (II)....8 (ix) V.10 I Business Risk This risk inherent for an organization due to its operations is called business risk. It is the risk of a firm when it uses no debt. Technically or in terms of formulation it is the uncertainty in the future returns on assets of a firm (ROA). We can write ROA as: Return on Assets (ROA) = N.I. to Common Stockholder + Int. Payment Assets (Brigham, 1996) For a firm using zero-debt (Un-levered Firm) ROA = ROE = N.I. to Common Stockholder Assets This gives us a way to measure the business risk of an un-levered firm i.e. measuring deviations in the ROE of that firm. Such a business risk is called firm's Basic Business Risk. "Business risk is the uncertainty associated with operating cash flows of a business. There are different dimensions of business risk, namely sales risk and operating risk (mtholyoke, 2007)". Variations in business risk not only depend on the type of industry a firm is operating in but also varies within the industry from firm to firm. Business risk's dependence is influenced by six common factors. a) Demand Variability the more the variations in demand of a firm's product, the more will be its business risk b) Sales Price Variability firms which operate in a market where prices are stable faces low business risk as compared to the firms which operate in a highly volatile market. c) Input Cost Variability the firms who are weak on the supply side and have high variability in input costs are exposed to high risk d) Adaptability of output prices with changes in input prices the firms which are in command to change their output prices with changes in input prices are less exposed to business risk. e) Ability to develop new products in a timely, cost effective manner the more the industry requires introduction of new products in market, the more the firm will be exposed to business risk f) Degree of operating leverage the high the degree of operating leverage the firm is operating at, the more will be its business risk Operating Leverage the firms which have high degree of operation leverage i.e. a major portion of their operations depends upon fixed cost leaves their firms more exposed to business risk. That means a decline in sales will not decline the cost since major portion of cost is fixed therefore even a smaller decline in sales will lead to a larger decline in ROE. The firms operating with high degree of operating leverage have high break even to cover their fixed costs since: Break Even Quantity = Fixed Cost / (Price - Variable Cost) Financial Risk A Firm exposes itself to financial risk with the introduction of debt in its capital structure. This is due to the reason that raising capital though debt concentrates the risk on stockholders. When bearing business risk, the equity holders require an amount of return called the return on equity. When the same organization includes debt in its capital structure, it assumes financial risk i.e. stock holders are forced to assume all the business risk but in larger chunk as compared to an un-levered firm and therefore they ask for a higher return in the form of Return on Equity to bear that extra risk. II (a) Rate of Return required by Ordinary Shareholders before the issuance of New Debt Assuming that the Risk Class of the company remains unchanged: First we will calculate the Market Value of the Firm. Market Value of Firm = Market Value of Stocks issued + Retained Earning + Debenture Market Value of Stocks issued = Market Value x number of share outstanding = 2 x 160,000 = 320,000 Market Value of Firm = 320,000 + 100,000 + 320,000 = 740, 000 Market Value can also be calculated through a formula Market Value of Firm = Income Available to Common Stockholders / Ke + Debt = (EBIT - Interest Payment) / Ke + Debt Income Available to Common Stockholders = EBIT - Interest Payments, since this is a perfect capital market and taxes are ignored (assumptions given in question) Here, EBIT = Earning before Interest and Taxes Ke = Cost of Equity EBIT = 64000 Interest Payment = interest rate x Debt = 0.08 x 320,000 = 25,600 Market Value = 740,000 740,000 = (64,000 - 25,600) / Ke + 320,000 Ke = 0.09142 = 9.142 %. II (b) Rate of Return required by Ordinary Shareholders after the issuance of New Debt Assuming that the Risk Class of the company remains unchanged: First we will calculate the Market Value of the Firm. Market Value of Firm = Market Value of Stocks issued + Retained Earning + Debenture Market Value of Stocks issued = Market Value x number of share outstanding = 2 x 160,000 = 320,000 Debt = 320,000 (Previous) + 80,000 (New) = 400,000 Market Value of Firm = 320,000 + 100,000 + 400,000 = 820, 000 Market Value can also be calculated through a formula Market Value of Firm = Income Available to Common Stockholders / Ke + Debt = (EBIT - Interest Payment) / Ke + Debt Income Available to Common Stockholders = EBIT - Interest Payments, since this is a perfect capital market and taxes are ignored (assumptions given in question) Here, EBIT = Earning before Interest and Taxes Ke = Cost of Equity EBIT = 64000 (Previous) + 8000 (New) = 72,000 Interest Payment = interest rate x Debt = 0.08 x 400,000 = 32,000 Market Value = 820,000 820,000 = (72,000 - 32,000) / Ke + 400,000 Ke = 0.09523 = 9.523 %. III (a) Weighted Average Cost of Capital Assumption: the issuance of Debt puts the organization in different Risk Class having following features. Cost of Debt increases to 9 % (also assuming that this 9 % rate is required by all the lenders, previous as well as new) Shareholder's required rate of return = 15 % The Weighted Average Cost of Capital is calculated by the formula: WACC = Wd x Kd x (1- T) + We x Ke Here, Wd = weight of Debt, Kd = Cost of Debt Wd = Debt / Total of Debt + Equity = 400,000 / (400,000 + 160,000 + 100,000) = 0.606 We = Equity / Total of Debt + Equity = 260,000 / (400,000 + 160,000 + 100,000) = 0.394 Kd = 9 % Ke = 15 % WACC = 0.606 x 0.09 + 0.394 x 0.15 = 0.11364 = 11.364 % III (b) Amount of Additional Earnings necessary to maintain the same total value Firm Value = (Earnings - Interest Payments) / WACC + Debt Firm Value = 820,000 ( as in II) WACC = 0.11364 Debt = 400, 000 820,000 = (Earnings - 36000) / 0.11364 + 400,000 Earnings = 83,728.8 Additional EBIT Required = Current Earning - Old Earning = 83,728.8 - 72000 = 11,728.8 Additional Net Earnings Required = Current Net Earning - Old Net Earning Current Net Earning = 83,728.8 - 36,000 = 47,728.8 Old Net Earnings = 72,000 - 32,000 = 40,000 Additional Net Earnings Required = 47,728.8 - 40,000 = 7,728.8 IV) MM proposed the idea that under some assumptions (assumptions of MM propositions) the capital structure of the firm is irrelevant Assumptions for MM Propositions (i) Frictionless Markets: No Transaction Costs (ii) Same information is available to all (iii) No Taxes (iv) No Cost to Bankruptcy (v) Individuals can do the same financial transactions at the same prices as the firms do (vi) All cash flow streams are perpetuities (There are some other assumptions but only primary assumptions are included) Now MM-Proposition (I) says: A Firm's Total Market value is independent of its capital Structure (Mike Bukart, 2007). Or, V of Levered Firm = Value of Un-Levered Firm And MM-Proposition (II) says: A Firm's Cost of Equity is directly related to its Debt to Equity Ratio (RPI, 2007). By capital structure we means a firm's long terms sources of Capital, i.e. Debt and Equity. The proposition (I) is valid till the overall value of the firm remains same and only the composition of the capital structure is changed. For example total value of the firms is 100. Now no matter this 100 comprises of 50 of debt and 50 of equity or all equity financed or some other combination of the two. The over all value of the firm remains the same independent of its capital structure. Here in our example, the overall value of the firms is changing since it is acquiring new debt and changing its overall capital by raising new debt. MM proposition could hold its position and could be applied to this example if the firm were raising debt to buy back some of its stocks to keep the overall value of the firms same and then the change in capital structure would not have any effect on the overall value of the firm. Now raising the debt increased cost of equity, since the debt concentrates the absorption of business risk to the stock holders and in return they ask for more compensation for bearing this risk. According to MM proposition (II): Expected Return on Equity = Expected Return on Assets + Debt/Equity x (ROA - Kd) ROE = ROA + D/E x (ROA - Kd) (Brealey et al. 2007) Considering this equation we can see that as the firms raised its Debt to equity ratio the cost of equity required by stockholders increases. For example in part II it increases from 9.142 % to 9.52 %. Similarly in part 3 it was seen that the firm's cost of capital increased that is WACC increased as the firms raised new debt as this put the firm in a new risk class which made it more riskier in the eyes of stock holders and their required rate of return jumped form 9.53% in part (II) to 15 % (given) in part (III). V Capital Structure and Its Importance The firm's capital structure decisions are the decisions that require deciding how a company will shape its capital structure. How much of it will be financed through debt and how much of it will be financed through equity. If the company is all financed through equity then the shareholders own the assets of the company and their required return equals the cost of equity. In this case share holders bear all the risk (business Risk) inherent in the operations of business. But in real life we see organizations are financed through a mix of different type of securities. This includes debt, common stock and preferred stock. These different securities have different risks attached to them and therefore have different costs associated with them for their utilization. These costs then become require rate of return for the investors investing in these securities. And this leads to the point that the company's cost of capital no longer remains the cost of any one of the constituent, rather it becomes the weighted average cost of capital and this WACC is calculated by calculating the weighted average of costs of each source of financing. Now this WACC becomes very important in deciding whether to go for an investment or not. Companies decides upon different types of investment by looking that whether the funding required for the investment is increasing their WACC or not and how much return will be generated by the project. Hence the right capital structure decision can help organization to select and invest in projects and operations that will be profitable to the organization in literal sense since "recall that the goal of management is to maximize the value of the firm (Ualr, 2007)". (Word Count: 1941 excluding executive summary) Bibliography Brigham E.(1996). "Business Risk". Financial Managmement: theory and Practice by Eugene F. Brigham. Eighth Edition. ISBN: 0-03-017789-8 Bearly Myres & Marcus (2006). "MM propositions". Corporate Finance by Bearly, Myres & Marcus. 4th Edition. Mike Bukart, (2007). "Modigliani and Miller's Theorem". Retrieved on April 23, 2007: http://www.nes.ru/sstepanov/lecture7mm.pdf mtholyoke, (2007). "Types of Risks". Retrieved on April 23, 2007: http://www.mtholyoke.edu/vvstepan/CorporateFinanceWeb/typesrisk.htm#brisk RPI, (2007). "Capital Structure". Retrieved on April 22, 2007: http://www.rpi.edu/hasan/MGMT%206966/FM/F-15_16.ppt#258,3, Study of Capital Structure (CS) Ualr (2007). "Capital Structure Theory and Cost of Capita". Retrieved on April 22, 2007: http://www.ualr.edu/haterry/capital.htm Read More