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RISK ANALYSIS
RISK ANALYSIS
Credit risk
The possibility that an entity will not be able to meet debt payment obligations on time
small amount of debt low fixed cost commitments a low default probability
Changes in the economy Industry-specific conditions A high degree of leverageleveraged firms have greater exposure to business risk than conservatively structured entities
Bankruptcy risk
Extreme case of credit risk, whereby a firm may be unable to continue as a going concern Financial distress, or the difficulty in meeting maturing obligations, is the first sign of bankruptcy risk A company in financial distress might file for bankruptcy protection
A bankrupt firm
Losses autonomy in conducting its operations Can have its debts rearranged, reduced, or eliminated with the mutual consent of the company, creditors, and court Will liquidate, or go out of business, if continuing operations is not a viable option
Short-term creditors finance current assets Long-term investors finance long-term assets
To determine if the proportion of debt to equity enables an entity to create wealth without unduly jeopardizing the firm
Consists of long-term liabilities, preferred stock, common stock, and retained earnings. Sufficient equity must exist to provide financial stability Debt can be used as leverage to increase returns to shareholders, but it can also reduce returns on shareholders investments
FINANCIAL LEVERAGE
The substitution of fixed-charge financing for variable-cost (dividend) equity financing Financial leverage concepts
The traditional view is that an optimal mix of debt and equity exists Research demonstrated that the mix of debt and equity is irrelevant, if taxes are ignored The tax deductibility of interest expense creates an advantage for incurring debt
Measures the percentage of assets financed with debt Is computed as: average total debt / average total assets