Business Finance 2 Dersi 3. Ünite Sorularla Öğrenelim

What does Net Income Approach advocate?

The net income approach advocates that a firm can boost its value by lowering its WACC, which is possible by increasing financial leverage in its capital structure. In this approach, it is assumed that the cost of debt is always less than the cost of equity and that the increase in the debt ratio does not lead to a change in the risk perception of the investors.

Why do equity financing become more expensive than debt financing?

Firms raise equity funds from their shareholders, who own a direct share of the net income and the
net worth of the company. As shareholders hold residual claims on both the earnings and the assets of
the business, they bear more risk than the creditors. Therefore, equity financing becomes more expensive than debt financing. Furthermore, as more debt is raised, the risk borne by the shareholder’s increases, leading to a higher cost of equity.

What are the factors influencing the business risk of a firm?

There are many factor explainin it but the main factors are listed below:

• Shifts in the demand for the products/ services of the company. Higher volatility of demand for the products/services of the firm escalates the business risk.
• Fluctuations in thesales price dueto market volatility. Firms operating in markets with
high output price variations are prone to higher business risk.
• Changes in input costs. Uncertainty and excessive volatility in input costs raise the
business risk.

• The cost structure of the company, especially the level of the fixed costs in total
costs which are measured by the degreeof-operating leverage (DOL). If the DOL
is high, the firm will be exposed to higher business risk.
• The ability to adapt cost-effective measures to changes in both the input costs and
output prices. Some firms can quickly implement cost-effective processes to adjust
to the fluctuations in input costs or output prices. This ability reduces the business risk
faced by the company.

How is the value of the firm measured?

The value of the firm is measured as the sum of the value of the firm’s equity and the value
of the debt.

When does Asymmetric information occur?

Asymmetric information occurs when one party from a financial transaction has
different information than the other.

Explain the Net Operating Income Approach.

The model assumes that the cost of debt, the WACC and the value of the firm is irrespective of financial leverage. The value of the firm is its net operating income which is also independent of leverage, capitalized at the constant WACC. Therefore, the firm value will remain unchanged by the financing decisions under the assumption of no corporate taxes. The cost on the borrowings is a constant no matter the amount of debt capital. However, utilizing higher levels of financial leverage in the capital mix increases the risk borne by the shareholders. As a result, the cost of equity rises relative to the increase in leverage, but the
rise in the cost of equity is offset by the lower cost on the borrowings.
Hence, the WACC remains constant at all possible levels of leverage

Explain the role of Firm-Specific Factors on capital structure.

 Each firm has unique features affecting its asset structure, risk appetite, and competitive strength. The firm age, size, and its legal status are among other elements that
impact capital structure. Additionally, the performance of the company, its short and long-term solvency, its level of leverage determines its creditworthiness. Credit-worthy businesses can have easy access to available funds both in debt and equity. Thus, they will enjoy more flexibility in capital structure decisions.

Explain financial risk.

Financial leverage is an indicator of financial risk and occurs in case of borrowing. Financial risk is the additional risk borne by the stockholders when the company raises debt
financing. 

What does bankruptcy risk refer to?

Bankruptcy risk refers to the likelihood that a company will be unable to meet its debt
obligations. 

LMN and STU aretwo identical firms other than their capital structures. Both companies
generate EBIT of $10,000 and pay 20% corporate taxes. LMN is an unlevered firm with total equity of $100,000 and STU is a levered company with $50,000 of debt and $60,000 of the equity issue. The interest rate on STU’s borrowing is 10%.If we have 10% of the shares in both LMN and STU, let’s discuss the MM’s assumption that the value of the
levered firm is equal to the value of the unlevered firm plus the tax shield on debt (VL=VU+D*T).

Value of STU (levered firm)=$50,000+$60,000=$110,000
Value of LMN (unlevered firm)=$100,000
Value of LMN=Value of STU+$10,000=$100,000+ ($50,000*0.20)
If you have 10% of the shares of LMN (unlevered firm), your shares will be worth:
0.10*$100,000=$10,000 and your share of the income will be:
0.10*$10,000=$1,000
If you have 10% of the shares of STU (levered firm), your shares will be worth:
0.10*($110,000-$50,000)= 0.10*$60,000=$6,000 and your share of the income will be:
0.10*($10,000-(0.06*$50,000))= 0.10*($10,000-$3,000)=$700

What does Agency Theory suggest?

Agency theory suggests that agency problems may arise if managers (agents) pursue different objectives other than those of the shareholders (principals). Shareholders’ seek for wealth maximization which can be attained by the maximization of the value
of the firm.

How does economic environment effect capital structure?

The economic conditions in general impact the investment and financing decisions simultaneously. The economic policies of the country where the company is established to determine the market conditions shaping up both the forces of demand and supply. The political and economic stability affect the level of risk at the macro and micro levels.

Explain "NOPAT" and "ROIC". 

The return on invested capital (ROIC) measures the operating profitability on capital investments. NOPAT is the net operating profit after taxes and the capital is the amount of capital investment required for the persistence of the operations. The variance in the ROIC is an indicator of the business risk and a higher variance demonstrates a higher business risk. 

How do Industry Specific Factors have an effect on capital structure?

As products differ, the demand and supply mechanisms of each industry are unique. Therefore, the size and type of investments vary across industries which necessitate financing under different capital structures. The intensity of the industry-wide competition displays a significant effect on capital structure decisions since value maximization is straitened under heavy competition. Demand volatility may also alter financing decisions in favor of equity issues to balance out the business risk which may raise the WACC and deteriorate firm value.