BUSINESS & FINANCIAL RISK

The following concept will be discuss :

Factors on which Business risk depends Measurement of ROIC, EBIT Break Even Point Understanding of Operating Leverage What is Business risk (inheriting) What is Financial risk (arise due to debt) Making Decision

BUSINESS & FINANCIAL RISK

Introduction of two dimensions of risk 1- Business Risk ( If uses no debts) The risk is beared by firms stock 2- Financial Risk (If uses of debts) The risk burden shifts on Stockholders

BUSINESS & FINANCIAL RISK

1- Inherently each firm has certain amount of risk in its operation it is known as business risk. 2- If firm uses any debt, then it is partitioning its investors into two groups.

Common Stockholders

Stockholders of leveraged

If half of the capital of the firm is raised as debt and half as common equity.

BUSINESS & FINANCIAL RISK

The greater the use of the debt, the greater the concentration of risk on stockholders, and the higher the cost of the common equity. The business risk and financial risk in the stand-alone framework.

BUSINESS & FINANCIAL RISK

We do not know for sure how large operating profit will be, nor do we know how much we will have to invest to develop new products, build new plants, and so forth. The return on invested capital (ROIC) combines here these two sources of uncertainty, and its variability can be used to measure business risk on a stand alone basis.

BUSINESS & FINANCIAL RISK

Formula : ROIC = NOPAT = EBIT (1-T) Capital Capital NOPAT= Net Operating Profit After Tax

Required Operating Capital = Debt + Common Equity If the firms required capital is stable then we can use variability in EBIT (Earning before income tax)
EBIT

BUSINESS & FINANCIAL RISK STRASBURG ELECTRONIC COMPANY

DEBT-FREE (UNLEVERED FIRM)
TREND IN RETURN ON INVESTED CAPITAL (ROIC)
ROIC %
Expected ROIC

20

12% 10 8%
Actual ROIC

8.5%

96

98

00

02

04

-10

BUSINESS & FINANCIAL RISK BUSINESS RISK FACTORS

Demand Variability: The more stable demand, the lower is the business risk. Sales Price Variability:
business risk. The higher the variability in the price of the goods, the higher the

Input Cost Variability: Firms whose input costs are highly uncertain are exposed to a high
degree of business risk.

Ability to adjust output prices as input costs rise: The greater the ability to adjust
output prices to reflect cost conditions, the lower the business risk

Ability to develop new product: Firms in high-tech industries as drugs and computers
depend on a constant stream of new products. The faster its products become obsolete, the greater a firms business risk.

Foreign Risk Exposure:

Firms that generate a high percentage of their earnings overseas

are subject to earnings declines due to exchange rate fluctuations.

The extent to which costs are fixed: If a high percentage of its costs are fixed, here do not
decline when demand falls, then the firm is exposed to a relatively high degree of business risk. This factor is knows as OPERATING LEVERAGE .

BUSINESS & FINANCIAL RISK OPERATING LEVERAGE

In

physics: Lever to raise a heavy object with small force. In politics: If people have leverage, their smallest word action can
accomplish a lot.

In

Business : Small change in sales results in a large change in EBIT

The higher the fixed cost , the greater its operating leverage

BUSINESS & FINANCIAL RISK CAPITAL INTENSIVE

Higher

fixed costs are generally associated with more highly automated capital intensive. Highly skilled workers who must retained and paid even during recessions.

BUSINESS & FINANCIAL RISK

Degrees Of Operating Leverage Plan A
Price Variable
Rs.2.00 Rs.1.50 Rs.20,000 Rs.200,000 Rs.40%

Plan B
Price Variable
Rs.2.00 Rs.1.00 Rs.60,000 Rs.200,000 Rs.40%

Cost Fixed Cost Capital Tax Rate

Cost Fixed Cost Capital Tax Rate

BUSINESS & FINANCIAL RISK

BreakBreak-even point Plan A Plan B EBIT =PQ-VQ-FC=0 =PQ-VQEBIT =PQ-VQ-FC=0 =PQ-VQQB E = F QB E = F P-V P-V QBE = 20,000 = 40,000 units QBE = 60,000 = 60,000 units
2.00 1.50 2.00 1.00

BUSINESS & FINANCIAL RISK

Plan A
Demand probability Units Sold SALES Operating Cost EBIT NOPAT ROIC Operating Cost

Plan B
EBIT NOPAT ROIC

Terrible Poor Normal Good Wonderful Expected Values

0.05 0.20 0.50 0.20 0.05

0 40,000 100,000 160,000 200,000 100,000

0 80,000 200,000 320,000 400,000 200,000

20,000 80,000 170,000 260,000 320,000 170,000

(20,000) 0 30,000 60,000 80,000 30,000 24,698 0.82

(12,000) 0 18,0000 36,000 48,000 18,000

-6.0% 0 9.0 18.0 24.% 9.0% 7.4% 0.82

60,0000 100,000 160,000 220,000 260,000 160,000

(60,000 ) (36,000 ) (20,000) 40,0000 100,000 140,000 40,000 49,396 1.23 (12,000) 24,000 60,000 84,000 24,000

-18.0% -6.0% 12.0% 30.0% 42.0% 12.0% 14.8% 1.23

Standard Deviation Coefficient of Variation

Notes : a Operating Cost =Variable Cost + Fixed Cost

b C -d -E -NOAT = EBIT (1- Tax rate )= EBIT (0.6) ROIC = NOPAT / Capital Standard deviation and Coefficient of variation through formula or procedure Break of plan B not shown in Table but it is 60,000 units

BUSINESS & FINANCIAL RISK

Comparison Of plan A and B Plan A

Plan B

Lower operating Leverage Lower EBIT from -20000 to 80,000 is lower as 7.4% (Rs.24,698 ) ROIC range -6.0% to 24% Not much riskier (EBIT Rs.30,000) ROIC = 9%

Larger operating Leverage Larger EBIT from -60000 to 140,000 is higher as 14.8% (Rs.49,396 ) ROIC range -18.0% to 42% Much riskier (EBIT Rs.40,000) RROIC = 12%

BUSINESS & FINANCIAL RISK

Decision Of Management

The Strasburg needs to make a choice with less risk less return more risk more return. The Strasburg, for the rest of the analysis, decide to go ahead with high risk high return with Plan B because management believe that the higher expected return is sufficient to compensate for the risk. Electric Utilities, telephone, airline, steel mills , and chemical companies simply have large investment in fixed Assets this result in high fixed cost and operating leverage. Grocery stores , on the other hand , generally have significantly lower fixed costs, hence lower operating leverage.

BUSINESS & FINANCIAL RISK

Financial Risk

DEBT-USING (LEVERED FIRM)

If a firm uses debt (Financial Leverage , this concentrates its business risk on its common stockholders. Suppose that the firm is capitalized with 50 % debt and 50% equity (Total 10 persons invest money In the firm Five putting up their money as debt and other five as equity). In this case , the five investors who put up the equity will have to bear virtually all of the business risk.. Common stock is more riskier than it would have been had the firm been financed only with equity.

BUSINESS & FINANCIAL RISK

Effects of Financial Leverage
Demand Terrible Poor Normal Good Wonderful Expected Values Standard Deviation Coefficient of Variation Demand probability EBIT Interest Pre Tsx Tax Rate NOPAT income 40% (28,000) (12,000) 12,000 36,000 2,000 12,000 probability EBIT Interest 0% 0 0 0.05 (60,000) 0.20 (20,000) 0.50 0.20 0.05 40,000 Pre Tsx Tax Rate NOPAT ROE income 40% (60,000 ) (24,000) (36,000 ) -18.0% (20,000) 40,000 100,000 140,000 40,000 (8,000) 16,000 40,000 56,000 16,000 (12,000) 24,000 60,000 24,000 24,000 -6.0% 12.0% 30.0% 42.0% 12.0% 14.8% 1.23 ROE

Section I Zero Debt Book Equity =Rs.200,000

100,000 0 140,000 40,000 0 0

Section II Debt=100,000 Book Equity =100,000 Rate Of Interest = 10%

Terrible Poor Normal Good Wonderful Expected Values

0.05 (60,000) 0.20 (20,000) 0.50 0.20 0.05 40,000

10,000 (70,000 ) 10,000 (30,000) 10,000 30,000

(42,000 ) -42.0% (18,000) -18.0% 18,000 18.0% 54,000 34.0% 78,000 78.0% 18,000 18.0% 29.6% 1.65

100,000 10,000 90,000 140,000 40,000 10,000 130,000 10,000 30,000

Standard Deviation Coefficient of Variation

BUSINESS & FINANCIAL RISK

Analysis:

Financing with debt increases the common stockholders expected rate of return for an investment, but also increases the common stockholders risk . Financial leverage raises the expected ROE from 12% to 18% ,but it also Increases the risk of investment as seen by the increase in the standard deviation