Chap 13

1)

a) The difference between business risk and financial risk:

Business risk refers to the chance a business’ cash flows are not enough to cover its operating expenses like costs of goods sold, rent and wages,… Business risk is independent of the amount of debt a business owes. Unlike business risk, financial risk refers to the chance a business's cash flows are not enough to pay creditors and fulfill other financial responsibilities. The level of financial risk, therefore, relates less to the business's operations themselves and more to the amount of debt a business incurs to finance those operations. The more debt a business owes, the more likely it is to default on its financial obligations. Taking on higher levels of debt or financial liability therefore increases a business's level of financial risk.

b) Measuring the business and financial risk in a total risk sense:

Stand-alone risk = Business risk + Financial risk

Stand-alone risk = бROE

Business risk = бROE(U)

Financial risk = Stand-alone risk – Business risk = бROE – бROE(U)

c) Measuring the business and financial risk in a market risk framework:

The business and financial risk can be measured using the Hamada equation:

b = bu + bu(1 – T)(D/E)

b is the levered beta

bu is the unlevered beta

T is the tax rate

D/E is the ratio of debt to equity

According to the equation, the total market risk is equal to the unlevered beta which reflects the riskiness of the firm’s assets plus the increased volatility of the return to the equity due to the use of debt. Therefore:

Business risk = bu

Financial risk = bu(1 – T)(D/E)

d) Business risk affect capital structure decision: For a firm that has higher business risk, it tends to adopt a capital structure with less debt than a firm with lower business risk.

9) The effect of control issues to the capital structure decision:

Raising the level of debt will help to restrain the manager from making the ill – considered decisions...