CP

484 CHAPTER 13 Capital Structure Decisions

and for Plan B,

How does operating leverage affect business risk? Other things held constant, the higher

a firm’s operating leverage, the higher its business risk.The data in Figure 13-2 confirm

this, as shown in the much riskier EBIT of Plan A versus Plan B. The range of possi-

ble EBITs under Plan A is from $20,000 if demand is terrible to $80,000 if demand

is wonderful, for a total range of $100,000. For Plan B, EBIT goes from $60,000 to

$140,000, a total range of $200,000. In addition, the standard deviation of EBIT for

Plan A is $24,698 versus $49,396 for Plan B. Notice that even though Plan B is riskier,

it also has a higher expected EBIT, $40,000 versus the $30,000 expected EBIT of

Plan A. For the rest of this analysis, we assume that Strasburg decided to go ahead

with Plan B because they believe that the higher expected return is sufficient to com-

pensate for the higher risk.

To a large extent, operating leverage is determined by technology .Electric utili-

ties, telephone companies, airlines, steel mills, and chemical companies simplymust

have large investments in fixed assets; this results in high fixed costs and operating

leverage .Similarly, drug, auto, computer, and other companies must spend heavily to

develop new products, and product-development costs increase operating leverage.

Grocery stores, on the other hand, generally have significantly lower fixed costs,

hence lower operating leverage .Although industry factors do exert a major influence,

all firms have some control over their operating leverage .For example, an electric

utility can expand its generating capacity by building either a gas-fired or a coal-fired

plant .The coal plant would require a larger investment and would have higher fixed

costs, but its variable operating costs would be relatively low .The gas-fired plant, on

the other hand, would require a smaller investment and would have lower fixed costs,

but the variable costs (for gas) would be high .Thus, by its capital budgeting decisions,

a utility (or any other company) can influence its operating leverage, hence its busi-

ness risk.^6

Financial Risk

Financial riskis the additional risk placed on the common stockholders as a result of

the decision to finance with debt. Conceptually, stockholders face a certain amount

of risk that is inherent in a firm’s operations—this is its business risk, which is defined

as the uncertainty inherent in projections of future operating income. If a firm uses

debt (financial leverage), this concentrates the business risk on common stockholders.

To illustrate, suppose ten people decide to form a corporation to manufacture disk

drives. There is a certain amount of business risk in the operation. If the firm is cap-

italized only with common equity, and if each person buys 10 percent of the stock,

then each investor shares equally in the business risk. However, suppose the firm is

capitalized with 50 percent debt and 50 percent equity, with five of the investors

putting up their capital as debt and the other five putting up their money as equity.

In this case, the five investors who put up the equity will have to bear all of the busi-

ness risk, so the common stock will be twice as risky as it would have been had the

firm been financed only with equity. Thus, the use of debt, or financial lever-

age,concentrates the firm’s business risk on its stockholders .This concentration of

QBE

$60,000

$2.00$1.00

60,000 units.

(^6) See the Web Extension to this chapter for additional discussion of the degree of operating leverage.

480 Capital Structure Decisions