Summary Chapter 12 Determining the Financial Mix
Chapter 12
Determining the financing mix I. Risk * Variability associated with expected revenue or income streams. Such variability may arise due to: * Choice of business line (business risk) * Choice of an operating cost structure (operating risk) * Choice of Capital structure (financial risk)
a) Business Risk * Variation in the firm’s expected earnings attributable to the industry in which the firm operates. There are four determinants of business risk: * The stability of the domestic economy * The exposure to, and stability of, foreign economies * Sensitivity to the business cycle * Competitive pressures in the firm’s industry
b) Operating Risk * Operating risk is the variation in the firm’s operating earnings that results from firm’s cost structure (mix of fixed and variable operating costs). * Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues.
c) Financial Risk * Financial Risk is the variation in earnings as a result of firm’s financing mix or proportion of financing that requires a fixed return.
II. Break-even Analysis * Break-even analysis is used to determine the break-even quantity of firm’s output by examining the relationships among the firm’s cost structure, volume of output, and profit. * Break-even may be calculated in units or sales dollars. Break-even point indicates the point of sales or units at which EBIT is equal to zero.
Use of break-even model enables the financial manager:
1. To determine the quantity of output that must be sold to cover all operating costs, as distinct from financial costs.
2. To calculate the EBIT that will be achieved at various output levels.
Elements of Break-even Model
* Break-even analysis requires information on the following: * Fixed Costs * Variable Costs * Total Revenue * Total Volume
* Break-even
Determining the financing mix I. Risk * Variability associated with expected revenue or income streams. Such variability may arise due to: * Choice of business line (business risk) * Choice of an operating cost structure (operating risk) * Choice of Capital structure (financial risk)
a) Business Risk * Variation in the firm’s expected earnings attributable to the industry in which the firm operates. There are four determinants of business risk: * The stability of the domestic economy * The exposure to, and stability of, foreign economies * Sensitivity to the business cycle * Competitive pressures in the firm’s industry
b) Operating Risk * Operating risk is the variation in the firm’s operating earnings that results from firm’s cost structure (mix of fixed and variable operating costs). * Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues.
c) Financial Risk * Financial Risk is the variation in earnings as a result of firm’s financing mix or proportion of financing that requires a fixed return.
II. Break-even Analysis * Break-even analysis is used to determine the break-even quantity of firm’s output by examining the relationships among the firm’s cost structure, volume of output, and profit. * Break-even may be calculated in units or sales dollars. Break-even point indicates the point of sales or units at which EBIT is equal to zero.
Use of break-even model enables the financial manager:
1. To determine the quantity of output that must be sold to cover all operating costs, as distinct from financial costs.
2. To calculate the EBIT that will be achieved at various output levels.
Elements of Break-even Model
* Break-even analysis requires information on the following: * Fixed Costs * Variable Costs * Total Revenue * Total Volume
* Break-even