What is difference between financial and business risk

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Reference no: EM131327741

Summary of what she knows about the BestFit cross fit chain:

EBIT was $55 million in 2016, and is expected to remain constant for 2017. The firm is all equity financed, and there are 15 million shares outstanding. The corporate tax rate is 37.5%, the risk-free rate is 3.5% and the market risk premium is 4%. The firm’s beta was estimated at 1.25 by the investment bankers who have also supplied the following estimates of debt costs for different capital structures: At 20 percent debt, the cost of debt would be 6.3%; at 30 percent debt, the cost would be 7.5%; at 40 percent debt, the cost would be 8.7%; at 50 percent debt, the cost would be 10%.

Using the free cash flow valuation model, explain how capital structure can affect value.

Per’s wife Agnetha is also interested in participating in the venture, but has very little understanding of business or business finance. Even though her only role would be that of a silent investor, she would still like to understand the strategic financing decisions. She was told that the firm would be better off if some debt financing were used, but she did not entirely understand how. She would like a short explanation of the following:

What is the difference between financial and business risk?

What factors influence a firm’s business risk? Its financial risk?

What is operating leverage, and how does it affect a firm’s business risk? Use an example where fixed costs are $200, selling price is $15 and variable costs are $10

How would the use of debt change the income statement? Use a simplistic example of a fictitious firm that has $20,000 in assets, a tax rate of 37.5%, and an expected EBIT of $3,000. Construct two side-by-side “mini” income statements showing EBIT, EBT and NI.

Calculate BEP, ROI, ROE and TIE ratios for the fictitious firm with no debt and for the firm with 50 percent debt financing. Interpret your findings.

Briefly outline the implications for managers --- under which conditions should a firm issue debt?

For each capital structure under consideration for the pizzeria chain (see given information above), find the levered beta, the cost of equity and the WACC.

Using the WACC values found in g, find the corporate value. At which level of debt would the firm value be maximized?

Reference no: EM131327741

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