This risk or uncertainty concerns that an organization may witness decline in profitability or might suffer from losses in any financial accounting period. Business risks originate from different uncertainties such as changes in consumer tastes, change in preferences and buying behavior, modifications to government policy as well as increase in intensity of competition etc. business risks also stem from those unforeseen or unexpected events that may cause a business to fail in future .
Business risks are not just related to an organization as a whole. Different departments of an entity face numerous business risks that are unique to their operational activities. For instance, the production department of a manufacturing entity may face business risk due to irregular supply of inputs, labor unrest as well as equipment breakdown or fixed asset impairment etc. the marketing department of an entity may face business risks arising out of changes in consumer preferences and tastes, fluctuations in market prices of a commodity and changes in trends and fashion etc. Unwanted interruptions in the business activity due to any natural disaster and political unrest are the other business risks an organization may face.
This financial management terminology refers to the extent to which an organization or its projects employ fixed and variable costs in operations. Business for which fixed costs are higher than their variable costs are referred to as highly leveraged. In contrast, if variable costs of a business are more than its fixed costs, such a firm can be thought of as less leveraged.
In true essence, the operating leverage of a firm is related to or linked with its sales revenue generation capacity. This is because operating leverage concerns not only as a measure of how growth in sales revenue would increase the business income but it also attempts to magnify the volatility or uncertainty in firm’s operating income. Any firm that generates less revenue in sales would result in lower gross margin. Such a firm will be highly leveraged since it would be unable to absorb its fixed costs .
In other words, the fixed cost absorption capacity of firm with fewer sales will be lower and operating leverage would be high. Vice versa would be the situation if a firm generates higher sales revenue and its operating leverage would be low. Therefore, one can say that as any business generates more sales revenue, each sale contributes more to profitability as such organization can easily pay-off its fixed costs.
This pertains to the concept that shareholders of common equity would lose their investments if they invest in a firm with higher debt levels in the capital structure. With higher debt levels, there is a financial risk that the firm will default on its loans if it is unable to repay not only the principal amount but the regular and fixed payments of interest expense as well. In the same manner, financial risk concerns the financial loss incurred by market investors due to decline price per share of any publicly traded company. This form of financial risk stems from unfavorable fluctuations and instability in market price per share, foreign currencies and the level of interest rate.
There are various types of financial risk. One form of financial risk is that a firm would be unable to pay its creditors due to weaknesses in liquidity management practices. Similarly, due to failure of meeting its obligations, a company may be assigned a lower credit rating which is another form of financial risk known as settlement risk. Much of this kind of financial risk related to the use of debt in the capital structure .
Capital Structure Theory
Capital structure concerns the manner or extent to which equity and debt financing is utilized in the business operations of an organization. Equity financing include sharing of outstanding shares in the capital markets for the addition of new partners, members or shareholders to current business in return for financial contributions. Debt instruments may involve asset-backed securities and bank loans. The capital structure of an organization directly influences its capability to expand its business operations and remain solvent over the longer term period .
In other words, capital structure theory concerns a systematic approach and the manner in which business and its assets are financed by debt, equity and hybrid instruments. It is synonymously used as financing mix or financial leverage. According to capital structure theory, financial leverage refers to the extent to which an organization utilizes debt or borrowed money into its capital structure which is the most important and critical decision for every firm. For any publicly traded company, two broader categories of capital financing involve equity and debt where the capital structure theory states that interest payments are tax deductible sine they are considered a cost of doing business.
Concerns of the Capital Structure Theory
The capital structure theory deals with a very critical decision about the management of financial leverage into business operations. This theory questions the extent to which debt and equity sources of financing should be used in the capital structure that aims to maximize firm’s value as well as stakeholder value. As per the capital structure theory, the objective of an optimal financing decision concerns the maximization of shareholder wealth as well as increasing the value of an organization as a whole. The major concern of the capital structure theory is whether a particular financing mix of debt and equity would result in increase in the value of the firm or will it remain the same. To answer this concern or query embedded in the capital structure theory, four different approaches will be studied in the later section.
However, this should be kept in mind that whatever the financing mix is utilized in the capital structure and whether the value of the firm changes or not, capital structure theory is not concerned with the maximization of the level of operating income for any given organization. This is so because whatever the debt level is employed by an entity, the resulting interest payments to be paid in fixed and regular intervals affect the net income and Earnings per Share (EPS) instead of the operating income.
According to the capital structure theory, if more debt is employed into business operations, it would result in an increase in the payments of interest expense to lenders on fixed and regular intervals. This would certainly the net income available for taxation since interest payments are considered a cost to the business and so, they are tax deductible. Here, the Earnings per Share (EPS) would decline and so would the value of the firm as per the general belief in the capital market.
In contrast, if the internal management of an organization increases the equity stake into the business and retires some portion of the borrowed money (debt) or the interest rate in an economy reduces in light of monetary policy announcement, decline in interest payments would result in more net income available for tax deduction. In this case, the increase in Earnings per Share (EPS) of an entity would be regarded by the market forces as increase in the firm’s value since more earnings are made available to equity shareholders on books regardless of whether they are distributed as dividends or not.
Importance of the Capital Structure Theory
The capital structure theory considers an important financial decision for a firm because it relates that though the increase or decrease in the financial leverage and financing mix could modify the value of the firm, yet it never comes without a cost. If the internal management increases the financial leverage, the bankruptcy and default risk of a firm increases. Higher debt obligation would increase the operating leverage or fixed cost of an entity in terms of increased payments of fixed interest expense. Therefore, the capital structure is an important consideration to reach an optimum level of capital structure for an organization.
Important Theories or Approaches to Capital Structure
Capital structure states that by changing the capital structure, a firm’s value can be influenced. There are three approaches to a capital structure theory which are elaborated in succinct detail as follows:
1st - Net Income Theory of Capital Structure
This first theory is mainly concerned with increasing the firm’s market value while the overall cost of capital is reduced. This theory states that if more debt is employed in the capital structure and equity capital is retired, the market value of an organization increases and cost of capital declines. It is so because debt stands as a cheaper source of financing as interest payments are considered tax deductible. After paying interest expense, the firm would be required to pay less tax.
2nd - Net Operating Income of Capital Structure
This approach to capital structure theory rejects the idea presented the first model of capital structure which has already been discussed above in this paper. This capital structure theory states that changing the capital structure does not necessarily results in modifications in market value of firm and overall cost of capital.
3rd - Traditional Theory of Capital Structure
This approach to capital structure considers cost of capital as the major product of financing mix. The unique characteristic of this traditional approach is that it proposes the utilization of optimal or best possible combination of capital structure in business operations. This form of capital mix implies a specific ratio of different sources of capital depending on the unique financing needs of a firm. This approach proposes that the optimal level of capital structure is the one where the value of the firm increases while its cost of capital is declines to a lowest possible level.
The traditional approach to capital structure comprises of three different stages or phases. At the initial or very first stage, a firm must increase the debt usage in its financing mix to raise its market value. The second stage of traditional approach to capital structure theory, the publicly traded company should make industrious efforts to achieve an optimal level of debt and equity mix in the capital structure depending upon its financial needs. In this stage, not only the Weighted Cost of Capital (WACC) should be minimum but it must also result in an increase in the market value of firm with no further increase in debt capital in the financing structure. The third and last stage or phase of this traditional approach presents a warning that if the level of debt is further increased beyond the optimal level of financing mix, it would certainly result in an increase in cost of debt which would not only raise the overall cost of capital but would definitely reduce a firm’s value in the capital market.
4th - Modigliani and Miller Theory of Capital Structure
This theory approach or theory is in full disagreement of traditional approach. This theory relates that there exists no relation between cost of capital and capital structure. According to this theory, the cost of capital and value of the firm are fully influenced by expectations of market investors which is further affected by all those factors disregarded by traditional theorem of capital structure.
This MM approach, Modigliani and Miller model, (named after Franco Modigliani and Merton Miller) to capital structure theory presents two different propositions. According to the first proposal, the capital structure is irrelevant to firm’s market value where it is argued that the market worth of two identical firms is not affected by an increase or decrease in the debt usage. However, a firm’s value is surely affected by the expected future earnings. The second proposal in MM approach to capital structure theory states that increase in the financial leverage or use of more debt capital certainly raises the future earnings but not the value of a firm in the market. This is because more debt results in increase in interest expense which is tax deductible. So, fewer earnings are available for taxation in the corporate law .
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