Business risk is the possibility of the Company to experience losses due to uncertainties for, example, when customers intend to switch to a competitor. The likelihood of the firm to lose the expected financial return such as returns on the stock market is referred to as financial risk.
Business risk can be measured by use of scenario analysis. The company determines the impact that various scenarios may have in the business and how they can be mitigated. Western company can also measure financial risk by use of unexpected loss measures like historical profit volatility.
In most cases when a company is operating under speculative risk; and the risk increases, the debt that would have been safe turns out to be a very dangerous debt. What happens to the business, because of the risk, may shape the business which will otherwise dictate whether a firm can borrow more money or not.
The activities of the industry have a direct effect on the operations of the business within the industry. The behavior of the Western Company’s competitors directly affects the decisions that Western makes: such as when to invest and what to invest.
To calculate the stock price, the company has to determine both the earnings of the firm and the total number of shares. The stock price is then calculated by dividing the earnings by the number of shares.
In a case where the company decides to issue a huge sum of dividends to the shareholders, the earnings will reduce, which will translate to a low stock price. The optimal capital structure of Western Company is 7.12 percent.
When the interest of any capital increases, the EPS of the company will also decrease, and this will decrease the stock price. EPS will be maximized when the stock price is high.
High business risk should be reduced as a precautionary step, which also leads to a reduced stock price. An increase in the risk of the company will increase the stock price, and that will cause a decrease in the EPS of the firm.
In MM’s theory, the market is assumed perfect without taxes, without bankruptcy and such considerations. The figures in the table, however, do not seem to be consistent with the theory.
The limitation of quantitative capital structure is the complexity and lack of transparency. With transparency issues, the method becomes very risky as it does not clearly explain possible uncertainties that may affect the firm. There is a high risk in using the quantitative method; as a result, Western Company experiences a high level of uncertainty. The very important thing that needs consideration is the level of leverage, which should be the real focus of the company.
This is because most companies that have suffered leverage problems such as banks have always failed in the end. The same can be traced to the main cause of the global financial crisis. Therefore, the qualitative method should be simplified to make it easier for faster interpretations to any user, even those who do not understand financial problems. The level of transparency of the qualitative method to the firm should also be improved to include important information that is considered very necessary. Finally, the target structure should be thought of as a range and not as a point of estimate; getting the exact point is not very practical.
Bond-rating at AA is the highest bond ranking which deals in credit quality investment. Bond-rating of AA shows that the company has both a high financial rating and financial strength. The company must be one that is trading so high in terms of the stock price in the stock market.
Potential investors when analyzing which company to invest in, first look at the credit rating of the firm. This is because a company that rate at AA is a company that has high potential in meeting financial obligations. Looking at the financial ability of the Western Company, the financial stability is not very strong and, therefore, does not fit being rated at the AA level. The company is currently facing both financial risks and business risk that threatens financial stability. The firm should target a lower credit rating such as BB which is slightly lower than AA.
The capital structure of any given firm can be changed to help leverage the return on equity. In the case of Western Company, they can decide to lower their capital structure from the current fifty percent to a lower percentage of thirty or even to raise it to a higher percentage of seventy percent. When the company chooses to do this, it should be made to be a gradual step as making it abrupt might interfere with the firm’s operations.
Lowering the debt ratio to thirty may interfere with the liquidity cash that the firm needs for its day-to-day operations. When the debt ratio is raised to seventy, the cost of borrowing may be so expensive for the company, which may limit the operations in the end. Before this is done, stakeholders need to be informed of the suggested changes as they will directly affect them.