Your counterparts on the management team
Your counterparts on the management team are concerned that an economic downturn could potentially impact the performance of the business given its current operating cost structure, financing mix, and inherent business risk. Using this backdrop, explain the concept of business risk, financial risk and the interaction. You should also incorporate the concepts of operating leverage (DOL) and financial leverage (DFL) into your explanation. Use a simplified or “generic” income statement (Sales -VC-FC…) to make your points very clear. How does the idea of an operating breakeven level of sales fit into this explanation?Part BAs a follow-up, one of your colleagues indicated they are still confused and has asked for a simple illustration of the financing issues. Using the data given below, develop an illustration that adequately demonstrates the effects of financial leverage (adding some debt to the capital structure) on the company’s performance.Data:Consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L which uses $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000. Construct a partial income statement for each firm, which starts with EBIT. What does this example illustrate about the impact of financial leverage on BEP? ROA? ROE? What happens to these metrics if the EBIT falls to $1,500? Rises to $4,000?
