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1.a. Business risk is the risk which is associated with core business activities, for

example, demands creation, supply, operations, production, raw material procurement

etc. If an organization fails to properly manage these activities then the probability of

impact of these failures on revenue becomes too high and the business can lose some

part of its sales. Due to lower revenue the profits of business get negatively impacted,

particularly in case where fixed cost is very high the magnitude will be very high.

While on the other side, financial risk is associated with the debt level of the business.

If the company has high level of debt in its capital structure then it has a liability to

pay to lenders. Payment comprises of interest and principal repayment. Higher is the

debt level higher is risk of defaulting.

b. Financial risk involves a company's capital structure. Such a risk can be measured bylooking into the debt/equity ratio of the company, the ratios that show the liquidity

position of the organization, etc. Business risk involves the economics of the firm.

Here we ask questions like how will these companies look ten years from now, do wehave barriers to entry (i.e. patents, economies of scale etc. more on this in the

economics lessons), etc.

c. We can measure these risks in a market framework by calculating Beta which furtherhelps us to calculate the required return on the common stock by a process called

Capital Asset Pricing Model (CAPM). This required risk can basically be the

opportunity cost of capital. Stocks with betas greater than one are more risky than the

market and betas of less than one are less risky. For example, a stock with a beta of

1.5 is expected to gain 1.5% when the market rises 1%.

d. Business risk has various implications on capital structure. If a firm uses more debtcapital to fund its activities, it risks not being able to generate enough additionalrevenue from its operations to make it worthwhile to pay interest. If it sees an

economic downturn coming on, a firm might prefer to use less debt to offset such

business risk. On the other hand, if the firm doesn't take on enough debt, it might miss

out on opportunities. Businesses also get a tax break on debt, since they don't have to

pay tax on the money they pay in interest charges. This may create an incentive for

businesses to take on more debt in their capital structure. Such tax benefits may

somewhat override concerns about business risk, from the firm's perspective.

3. Ab. Sequence of events are as follows:

y Firm announces recapitalization plany Investors reassess their views and estimate a new equity value .y New debt is issued and proceeds are used to repurchase stock at the new

equilibrium price.

y Shares bought equals Debts Issued divided new price per share

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y After the process company will have more debt and lower number ofcommon stock

9. Control will clearly be an issue. If the company is not leveraged peers may use leveragebuyout technique to gain control of the organization. On the contrary too much debt maycause bankruptcy as too much debt may pile up on the company which will be difficult tobe repaid.

10.a. Weakness of the above theories are:

y Costs of debt and equity are not consideredy Costs of business disruption has not been consideredy Difficult to calculate the appropriate tax ratesy Difficult to estimate variable like risk-free rate and market premium

b.