Capital Structure and Leverage:

............... risk is the single most important determinant of capital structure, and it is the riskiness inherent in the firm's operations if it uses no debt. It can vary from one industry to another and also among firms in a given industry. In addition, it can also change over time.

A commonly used measure of ...............risk is the standard deviation of the firm's return on invested capital (ROIC). Remember that ROIC doesn't vary with changes in capital structure, so the standard deviation of ROIC measures the underlying risk of the firm ..................considering the effects of debt financing. A number of factors affect ..................risk including: competition, demand variability, sales price variability, input cost variability, product obsolescence, foreign risk exposure, regulatory risk and legal exposure, and ......................... which is defined as the extent to which fixed costs are used in a firm's operations. These factors are determined partly by industry characteristics and partly by managerial decisions.

.....................is the extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure.

............ risk is an increase in stockholders' risk, over and above the firm's basic ..................risk, resulting from the use of ................leverage. The use of debt concentrates the firm's business risk on stockholders. Typically, using debt increases the expected rate of return for an investment. However, debt also increases risk to the common stockholders. More debt increases expected EPS but it also increases risk. When a firm is determining its optimal capital structure, it needs to balance these positive and negative effects of...................... leverage.

Capital Structure and Leverage: Introduction

Up to this point when we calculated a firm's weighted average cost of capital (WACC), we assumed that the firm had a specific target capital structure. However, target capital structures often change over time, these changes affect the risk and cost of each type of capital, and thus impact the firm's WACC. In addition, changes in a firm's WACC impact its capital budgeting decisions and its stock price. Many factors influence capital structure decisions and determining the firm's optimal capital structure is not an exact science. In fact, even firms in the same industry often have dramatically different capital structures.

Capital refers to investor-supplied fundsdebt, preferred stock, common stock, and retained earnings. A firm's capital structure is the mix of debt, preferred stock, and common equity used to finance the firm's assets. Capital structure theory suggests that some optimal capital structure exists that simultaneously ............................ a firm's stock price and ................... its cost of capital. The optimal capital structure strikes a balance between risk and return. A firm's target capital structure is generally set equal to the estimated optimal capital structure. However, the target may change over time as conditions change, but at any given moment, a well-managed firm's management has a specific structure in mind; and financing decisions are made so as to be consistent with this target capital structure.

Actual capital structures also change over time for two different reasons: as a result of deliberate actions or as a result of market actions. First, if a firm is not currently at its target, it may deliberately raise funds in a manner that moves the actual capital structure toward its target. Second, the firm could incur high profits or losses that lead to significant changes in book value equity as shown on the balance sheet and to a decline in its stock price. Similarly interest rate changes due to changes in the general level of rates and/or changes in the firm's default risk could cause significant changes in its debt's market value. Both of these changes could result in large changes in its measured capital structure.