Ellen Kauer has been registered for financial management course and sought help.

Question

Ellen Kauer has been registered for financial management course and sought help. During their conversations about the business risk and the optimal capital structure of a firm, the helper made the following statement:

The main factors that affect the business risk are the ability to adjust output prices and operating leverage and business risk is the uncertainty regarding the net income of a firm. For a levered firm 40/60 debt to equity ratio is the optimal capital structure, which always maximizes the value of a firm.

Do you agree or disagree with the helpers statement? Briefly explain.

Explanation / Answer

No I don't completely agree with the helper's statement. Business risk can be various types like economic risk, sector risk, industry risk, competitor's risk, technology obsoletion risk, uncertanity of cash flows including net income as well as geo political risks. It is a combination of various risks and cannot only be said risk regarding output prices, leverage and uncertainity regarding net income. Moreover there is no set formula that 40/60 debt to equity ratio is the only optimal structure to optimize value of firm but it depends and varies from sector to sector, a manufacturing company's optimal debt to equity ratio will be very different from software companies.

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