Principles of Managerial Finance

526 PART 4 Long-Term Financial Decisions

TABLE 12.9 Sales and Associated EBIT

Calculations for Cooke

Company ($000)

Probability of sales .25 .50 .25

Sales revenue $400 $600 $800

Less: Fixed operating costs 200 200 200

Less: Variable operating costs (50% of sales)  (^2)  (^0)  (^0)   (^3)  (^0)  (^0)   (^4)  (^0)  (^0) 
Earnings before interest and taxes (EBIT) $

0

$

1

0

0

$

2

0

0

Hint The cash flows to
investors from bonds are
less risky than the dividends
from preferred stock, which
are less risky than dividends
from common stock. Only
with bonds is the issuer
contractually obligated to
pay the scheduled interest,
and the amounts due to
bondholders and preferred
stockholders are usually
fixed. Therefore, the
required return for bonds is
generally lower than that
for preferred stock, which is
lower than that for common
stock.
other factors—revenue stability and cost stability—also affect it.Revenue stabil-
ityreflects the relative variability of the firm’s sales revenues. Firms with reason-
ably stable levels of demand and with products that have stable prices have stable
revenues. The result is low levels of business risk. Firms with highly volatile prod-
uct demand and prices have unstable revenues that result in high levels of business
risk.Cost stabilityreflects the relative predictability of input prices such as those
for labor and materials. The more predictable and stable these input prices are,
the lower the business risk; the less predictable and stable they are, the higher the
business risk.
Business risk varies among firms, regardless of their lines of business, and is
not affected by capital structure decisions. The level of business risk must be
taken as a “given.” The higher a firm’s business risk, the more cautious the firm
must be in establishing its capital structure. Firms with high business risk there-
fore tend toward less highly leveraged capital structures, and firms with low busi-
ness risk tend toward more highly leveraged capital structures. We will hold
business risk constant throughout the discussions that follow.
EXAMPLE Cooke Company, a soft drink manufacturer, is preparing to make a capital struc-
ture decision. It has obtained estimates of sales and the associated levels of earn-
ings before interest and taxes (EBIT) from its forecasting group: There is a 25%
chance that sales will total $400,000, a 50% chance that sales will total $600,000,
and a 25% chance that sales will total $800,000. Fixed operating costs total
$200,000, and variable operating costs equal 50% of sales. These data are sum-
marized, and the resulting EBIT calculated, in Table 12.9.
The table shows that there is a 25% chance that the EBIT will be $0, a 50%
chance that it will be $100,000, and a 25% chance that it will be $200,000.
When developing the firm’s capital structure, the financial manager must accept
as given these levels of EBIT and their associated probabilities. These EBIT data
effectively reflect a certain level of business risk that captures the firm’s operating
leverage, sales revenue variability, and cost predictability.
Financial Risk The firm’s capital structure directly affects its financial risk,
which is the risk to the firm of being unable to cover required financial obliga-
tions. The penalty for not meeting financial obligations is bankruptcy. The more
fixed-cost financing—debt (including financial leases) and preferred stock—a
firm has in its capital structure, the greater its financial leverage and risk. Finan-