Define each of the following terms: a. Capital structure; business risk; financial risk

a. Capital structure; business risk; financial risk

Explanation

Capital structure is when a company finances its assets by debt or equity. Combination of both debt and equity as per the firms' need is the best way in getting their assets financed.
 
Business risk refers to the potential risk that the common stockholders face when there is no debt in the company. A business risk arises when there is uncertainty about the future cash flows and profits of a company.
Business risk is influenced by the following determinants:

Variability in demand- It leads to fluctuations in operating income.
Production cost- It leads to fluctuations in operating leverage.

Financial risk refers to the risk arising due to an increase in the debt in the capital structure of a company which affects the equity stockholders of that company.

Verified Answer

Capital structure is the combination of debt and equity.
 
The risk arising due to the uncertainty in the future operating profits and capital requirements is known as the business risk.
 
Financial risk refers to the risk of financial losses to companies.

b. Operating leverage; financial leverage; break-even point

Explanation

Operating leverage measures the percentage of fixed cost in total cost. If the percentage of fixed cost is high then there is high degree of operating leverage and if the percentage of fixed cost is low then there is low degree of operating leverage.
 
Financial leverage is also known as trading on equity. It is when additional assets are acquired by the use of debt.
 
Break-even point is where cost is equal to revenue. It is calculated by dividing fixed costs of production by difference between price per unit and variable cost of production.

Verified Answer

Operating leverage is when fixed costs are used in a firm's operations.
 
Financial leverage is when fixed income securities are used in a firm's capital structure.
 
Break-even point is the point of sale where cost is equal to revenue.

c. Reserve borrowing capacity

Explanation

Reserve borrowing capacity refers to the ability to borrow money in any future date at a reasonable cost.
It states the amount of money which can be borrowed as and when opportunity arises at a reasonable cost.
This concept of reserve borrowing capacity is explained in trade-off theory of capital structure.

Verified Answer

Reserve borrowing capacity is when money is borrowed at a reasonable cost.