FINANCIAL

MANAGMENT
PRESENTED By;
MUHAMMAD AFNAN AHMED
H A S S A A N A N WA R
MUHAMMAD ARSLAN
A F TA B A L I
A(1) : Business Risk
ANSWER: BUSINESS RISK IS THE RISKINESS INHERENT IN THE FIRM'S
OPERATIONS IF IT USES NO DEBT. A FIRM'S BUSINESS RISK IS AFFECTED BY
MANY FACTORS, INCLUDING THESE:
(1)VARIABILITY IN THE DEMAND FOR ITS OUTPUT
(2) VARIABILITY IN THE PRICE AT WHICH ITS OUTPUT CAN BE SOLD,
(3) VARIABILITY IN THE PRICES OF ITS INPUTS,
(4) THE FIRM'S ABILITY TO ADJUST OUTPUT PRICES AS INPUT PRICES
CHANGE,
(5)THE AMOUNT OF OPERATING LEVERAGE USED BY THE FIRM,
(6) THE SELLING PRICES OF OUTPUT
(7) OTHER RISK FACTORS SUCH AS CHANGES IN REGULATION (E.G. TAX RATE,
INFLATION, ETC.)
A(2): Operating Leverage
ANSWER: OPERATING LEVERAGE IS THE EXTENT TO WHICH FIXED COSTS ARE
USED IN A FIRM'S OPERATIONS. IF A HIGH PERCENTAGE OF THE FIRM'S TOTAL
COSTS ARE FIXED, AND HENCE DO NOT DECLINE WHEN DEMAND FALLS, THEN
THE FIRM IS SAID TO HAVE HIGH OPERATING LEVERAGE. OTHER THINGS HELD
CONSTANT, THE GREATER A FIRM'S OPERATING LEVERAGE, THE GREATER ITS
BUSINESS RISK.
IT MEASURES THE SENSITIVITY OF A COMPANY'S OPERATING INCOME (OR EBIT -
EARNINGS BEFORE INTEREST AND TAXES) TO CHANGES IN ITS SALES VOLUME.
OPERATING LEVERAGE AFFECT A FIRM’S BUSINESS RISK IN A WAY THAT A HIGH
OPERATING LEVERAGE RESULT TO A HIGHER BUSINESS RISK. THIS IS BECAUSE
THE FIXED COST ASSOCIATED WITH THE PRODUCTION WILL BE CONSTANT AND
NOT VARY DESPITE THE DECLINE IN THE DEMAND.
B(1): FINANCIAL LEVERAGE AND FINANCIAL RISK
Financial leverage refers to the firm's decision to Finance with fixed-charge securities, such as debt and
preferred stock. It refers to the use of borrowed funds (debt) to finance the acquisition of assets with the
expectation that the income or capital gains from the new assets will exceed the cost of borrowing. The
primary objective of financial leverage is to increase the potential return on equity for shareholders.

Financial risk is the additional risk, over and above the company's Inherent business risk, borne by the
stockholders as a result of the firm's decision to finance with debt.

B(2);
Business risk depends on a Number of factors such as sales, cost variability and operating Leverage.
Financial risk, on the other hand, depends on only one Factor--The amount of fixed-charge capital the
company uses.
Additionally, business risks is the risk borne from the high operating leverage, while financial risk is a
risk is dependent of the firm's fixed-income securities.
Sales 1,100,000
Variable Costs (% of sales) 60%
Fixed Costs 40,000
EBIT (constant) 400,000
Assets 2,000,000
Earnings Dividends
Shares 80,000
Stock owned by Management 50%
Debt 0
Share Price (same as book price) 25
Tax rate 40%
Risk free rate 6%
Market risk premium 6%
Beta (unlevered) 1.00
WACC 12%
D(1): Optimal Capital Structure

• Optimal capital structure is defined

as the capital structure that will ensure
both the highest market value of the
firm and the lowest WACC. It is the
ideal debt to equity ratio that maximize
the company’s value and minimizes its
cost of capital.
• Target capital structure is defined as
the firm's target capital composition
which consists of debts, preferred
stocks, and common stocks, to be able
to finance the firm's future projects. It is
the specific debt-to-equity ratio that a
company aims to achieve and maintain
over the long term to support its
strategic goals and financial policies.
D(2):
Financial risk is the additional risk placed on the
common stockholders as a result of the decision to
finance with debt. Conceptually, stockholders face
a certain amount of risk inherent in a firm's
operations. When a firm uses debt (financial
leverage), it concentrates the business risk on
common stockholders.
Financing with debt increases the expected rate of
return for an investment but also increases the
probability of a large loss, thereby increasing the
risk borne by stockholders. As the amount of
money borrowed increases, the firm increases its
financial risk, leading to a lower bond rating and a
higher cost of debt. This is because higher debt
levels raise the likelihood of default, which
concerns lenders and rating agencies, resulting in
downgraded bond ratings and increased interest
rates on new debt.
E:
• If the business risk is higher than its original estimates, then the firm needs to decrease its debt portion on its
capital structure to decrease the possible risk that the firm is exposed to.

F:
Since it is difficult to quantify the capital structure decision, managers consider the following judgmental factors
when making capital structure decisions:
• 1. The average debt ratio for firms in their industry.
• 2. Pro forma TIE ratios at different capital structures under different scenarios.
• 3. Lender/rating agency attitudes.
• 4. Reserve borrowing capacity.
• 5. Effects of financing on control. 6. Asset structure.
• 7. Expected tax rate.
 G:
The use of debt permits a firm to obtain tax savings
from the deductibility of interest. So the use of some
debt is good; however, the possibility of bankruptcy
increases the cost of using debt. At higher and higher
levels of debt, the risk of bankruptcy increases,
bringing with it costs associated with potential financial
distress. Customers reduce purchases, key employees
leave, and so on. There is some point, generally well
below a debt ratio of 100 %, at which problems
associated with potential bankruptcy more than offset
the tax savings from debt. Theoretically, the optimal
capital structure is found at the point where the
 Point 𝐷1 is the debt level that indicates material marginal tax savings just equal the marginal
bankruptcy cost. bankruptcy related costs. However, analysts cannot
identify this point with precision for any given firm or
 Point 𝐷2​is the debt level in which the firm for firms in general. Analysts can help managers
meets its optimal capital structure. determine an optimal range for their firm's debt ratios,
 Blue line intersect is the amount of stock price but the capital structure decision is still more
where there is no associated debt. judgmental than based on precise calculations.
 H:
The asymmetric information concept is based on the premise that management's
choice of financing gives signals to investors. Firms with good investment
opportunities will not want to share the benefits with new stockholders, so they
will tend to finance with debt. Firms with poor prospects, on the other hand, will
How does the existence of asymmetric want to finance with stock. Investors know this, so when a large, mature firm
information and signaling affect capital announces a stock offering,
structure? investors take this as a signal of bad news, and the stock price declines.
Firms know this, so they try to avoid having to sell new common stock.
This means maintaining a reserve of borrowing capacity so that when
good investments come along, they can be financed with debt.
ANY QUESTIONS ??