FINANCE Corporate financial policy and R and D Management

The amount of financial risk that a firm carries helps set the capitalization
rate. If a firm’s financial structure carries too much borrowers’ risk, the
market may set a lower price for the shares than it would give for similar
shares with perhaps somewhat smaller earnings but less financial risk.
The ability of the firm to set up an optimum capital structure implies
the ability to discriminate against suppliers of funds, investors, individuals,
or financial institutions, with different preferences for income and aver-
sions to risk. Discrimination on one level leads to complex financial struc-
tures. It means that by raising funds through securities and contracts with
varying return and security provisions, the firm could lower its total finan-
cial costs. On a broader macro level, varying preferences for return and
risk implies that by a judicious mix of overall debt (financial risk) and eq-
uity, the firm could maximize the value of its shares (minimize the cost of
capital)—that is, achieve an optimum capital structure.
The theoretical trade-off for a given firm between the rate of return on
ownership capital (equity), the degree of financial risk (debt), and the mar-
ket preference yielding the maximum price for the shares is illustrated in
Figure 4.1. The financial risk factor is indicated indirectly in Figure 4.1. It is
shown on the horizontal axis, inversely related to the proportion of equity

Definition of Leverage—Profits and Financial Risk 45

FIGURE 4.1 Formal Solution of a Firm’s Optimum Capital Structure

OWNERSHIP CAPITAL RISK

RATE OF RETURN ON EQUITY CAPITAL

Market Indifference Pattern

between Rate of Return versus

Capital Stock (Risk) for Firm

Depicted

Transformation Curve between

Rate of Return and Capital

Stock (Risk)

O C

R E

D 1

I 3

I 2

I