CP

480 CHAPTER 13 Capital Structure Decisions

Briefly describe some ways in which the capital structure decision can affect the

WACC and FCF.

Business and Financial Risk

In Chapter 3, when we examined risk from the viewpoint of a stock investor, we dis-

tinguished between market risk,which is measured by the firm’s beta coefficient, and

stand-alone risk,which includes both market risk and an element of risk that can be

eliminated by diversification. Now we introduce two new dimensions of risk: (1) busi-

ness risk,or the riskiness of the firm’s stock if it uses no debt, and (2) financial risk,

which is the additional risk placed on the common stockholders as a result of the firm’s

decision to use debt.^4

Conceptually, the firm has a certain amount of risk inherent in its operations: this

is its business risk. If it uses debt, then, in effect, it partitions its investors into two

groups and concentrates most of its business risk on one class of investors—the com-

mon stockholders. However, the common stockholders will demand compensation for

assuming more risk and thus require a higher rate of return. In this section, we exam-

ine business and financial risk within a stand-alone risk framework, which ignores the

benefits of stockholder diversification.

Business Risk

Business riskin a stand-alone sense is a function of the uncertainty inherent in

projections of a firm’s return on invested capital (ROIC), defined as follows:

Here NOPAT is net operating profit after taxes and capital is the sum of the firm’s

debt and common equity, which is numerically equivalent to our definition of operat-

ing capital in Chapter 9. Business risk can be measured by the standard deviation of its

ROIC, ROIC.

To illustrate, consider Strasburg Electronics Company, a debt-free (unlevered)firm.

Figure 13-1 gives some clues about the company’s business risk. The top graph shows

the trend in ROIC from 1992 through 2002; this graph gives both security analysts

and Strasburg’s management an idea of the degree to which ROIC has varied in the

past and might vary in the future.

The lower graph shows the beginning-of-year subjectively estimated probability

distribution of Strasburg’s ROIC for 2002, based on the trend line in the top section

of Figure 13-1. As both graphs indicate, Strasburg’s actual ROIC in 2002 was only

8 percent, well below the expected value of 12 percent—2002 was a bad year.

Business risk depends on a number of factors, as described below:

1.Demand variability.The more stable the demand for a firm’s products, other

things held constant, the lower its business risk.

2.Sales price variability.Firms whose products are sold in highly volatile markets

are exposed to more business risk than similar firms whose output prices are more

stable.

ROIC

NOPAT

Capital



EBIT (1T)

Capital



Net income to

common stockholders

After-tax

interest payments

Capital

.

(^4) Preferred stock also adds to financial risk. To simplify matters, we concentrate on debt and common equity
in this chapter.

476 Capital Structure Decisions