RISK ANALYSIS

RISK ANALYSIS

Risk is the possibility of losing something of value

RISK ANALYSIS

Credit risk

The possibility that an entity will not be able to meet debt payment obligations on time

RISK ANALYSIS (CONT.)

Capital structure influences credit risk A firm with a conservative capital structure is a low credit risk because it has

small amount of debt low fixed cost commitments a low default probability

RISK ANALYSIS (CONT.)

Business risk Fluctuations in earnings and cash flow, due to

Changes in the economy Industry-specific conditions A high degree of leverageleveraged firms have greater exposure to business risk than conservatively structured entities

RISK ANALYSIS (CONT.)

Bankruptcy risk
Extreme case of credit risk, whereby a firm may be unable to continue as a going concern Financial distress, or the difficulty in meeting maturing obligations, is the first sign of bankruptcy risk A company in financial distress might file for bankruptcy protection

RISK ANALYSIS (CONT.)

A bankrupt firm
Losses autonomy in conducting its operations Can have its debts rearranged, reduced, or eliminated with the mutual consent of the company, creditors, and court Will liquidate, or go out of business, if continuing operations is not a viable option

RISK ANALYSIS (CONT.)

The equity markets determination of risk

Is a function of systematic risk Is inherent in investing Cannot be eliminated through investment diversity

RISK ANALYSIS (CONT.)

Beta measures of systematic risk

Is the extent to which a stock moves with the overall market In a range from 1.0 to +1.0 With an interpretation that he higher the beta, the greater a stocks variability

CAPITAL STRUCTURE MEASURES

Capital structure composition Financing activities should correspond to investing activities

Short-term creditors finance current assets Long-term investors finance long-term assets

OBJECTIVE FOR ANALYZING CAPITAL STRUCTURE

To determine if the proportion of debt to equity enables an entity to create wealth without unduly jeopardizing the firm

OBJECTIVE FOR ANALYZING CAPITAL STRUCTURE (CONT.)

Capital structure composition

Consists of long-term liabilities, preferred stock, common stock, and retained earnings. Sufficient equity must exist to provide financial stability Debt can be used as leverage to increase returns to shareholders, but it can also reduce returns on shareholders investments

FINANCIAL LEVERAGE
The substitution of fixed-charge financing for variable-cost (dividend) equity financing Financial leverage concepts

The traditional view is that an optimal mix of debt and equity exists Research demonstrated that the mix of debt and equity is irrelevant, if taxes are ignored The tax deductibility of interest expense creates an advantage for incurring debt

FINANCIAL LEVERAGE (CONT.)

The advantage of debt only exists up to a point

Low cost debt increases ROE relative to ROA Debt can become so costly that it reduces ROE below ROA

DEBT TO CAPITAL RATIOS

Provide insight about the proportion of debt to equity financing Total debt to total capital

Measures the percentage of assets financed with debt Is computed as: average total debt / average total assets

DEBT TO CAPITAL RATIOS (CONT.)

Total debt to total equity

Measures debt financing as a percentage of total financing Is computed as: average total debt / average total shareholders equity