CHAPTER 3

RISK AND
RETURN
Part 1
 Learning Objectives
By the end of the chapter, you should be able to;
Distinguish between business risk, financial risk and total
risk

Calculate the following indicators of risk

Break-even calculations
Degree of operating leverage
Degree of financial leverage

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 There is a trade-off between risk and
return

Return

Risk
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 What is Risk?
The word risk is usually used in a context of
potential hazard of possibility of an unfortunate
outcome resulting from a given action.
In financial management, risk also indicates the
expectation that the actual outcome of the project
may differ from the expected outcome.
The term risk and uncertainty are used
interchangeably

Financial Management 9e © Carlos Correia 4

 What is Business Risk?
Business risk refers to the nature of the business
itself and the uncertainty that surrounds the business
operating environment
This is reflected in variability of sales and costs and
the nature of the firm’s cost structure

Total Risk = Business Risk + Financial Risk

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 Variability of Costs
Relationship between fixed and variable costs

45,000,000 45,000,000 45,000,000

40,000,000 40,000,000 40,000,000
35,000,000
Sales Revenue 35,000,000 35,000,000
30,000,000 30,000,000 30,000,000
25,000,000 25,000,000 25,000,000
20,000,000 20,000,000
Fixed costs 20,000,000
Variable costs
15,000,000 15,000,000 15,000,000
10,000,000 10,000,000 10,000,000
5,000,000 5,000,000 5,000,000
- - -
0 5000 10000 15000 20000 25000 30000 35000 40000 45000 0 5000 10000 15000 20000 25000 30000 35000 40000 45000 0 5000 10000 15000 20000 25000 30000 35000 40000 45000

Fixed costs remain Variable costs

constant regardless are directly
of the sales volume. related to the
NB: For a given sales volume.
range.

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 Variability of Costs (continued)
50,000,000
Note how the
45,000,000
Total Cost
40,000,000 line does not
35,000,000 begin at zero.
30,000,000
Profit Why?
25,000,000
Sales revenue

Total Cost
20,000,000

15,000,000
Break-even
10,000,000
Loss
5,000,000

-
0 5000 10000 15000 20000 25000 30000 35000 40000 45000

The break even point is where Sales Revenue is equal to total costs
(fixed + variable costs). Neither profit nor loss is made.

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 Business Risk
Example:
Leverage Ltd has the following budgeted information
Fixed costs (FC) R10m p.a.
Variable cost (VC) R400 per unit
Selling price (S) R1000 per unit
Expected demand 30 000 units (minimum)

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 Business Risk
Break-even number of units
B/E = Fixed costs / contribution per unit
B/E = Fixed costs / (Selling price per unit – variable cost per unit)
B/E = R10m/(R1000-R400) = 16 667 units
B/Value = Fixed costs/Contribution % (or MI %)
= R10m/60% (600/1000)
= R16.667m (or 16 667 x R1 000)

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 What is the effect of volume on EBIT?
(Earnings before Interest & Tax)

No. of units 30,000 40,000 % change

Rm Rm
Sales (R1000 per unit) 30.0 40.0 33%
Variable costs (R400 per unit) 12.0 16.0 33%
Contribution 18.0 24.0 33%
Fixed costs 10.0 10.0 0%
EBIT 8.0 14.0 75%

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 Business Risk & Operating Leverage
How do we measure operating leverage?

S-VC 30.0 - 12.0

DOL = =
S-VC-F 8.0
= 2.25

This means an increase in sales of 10% will lead to an increase

of 10% x 2.25 that is 22.5% in EBIT.
In our example, sales increased by 33.3% and EBIT increased
by 33.3% x 2.25 = 75%.

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 Business risk
Assume now that Leverage Ltd decides to
install machinery which will increase fixed
costs by R5m per year and reduce variable
costs by R400 to R250 per unit
The new break-even units will be:
20 000 units. [15 000 000/(1000 – 250)]

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 Business risk
How will EBIT change now?

No. of units 30,000 40,000 % change

Rm Rm
Sales (R1000 per unit) 30.0 40.0 33%
DOL = 22.5/7.5 = 3. A 33.3% increase in sales has resulted in 100% increase in
Variable
EBIT.
costs (R250 per unit) 7.5 10.0 33%
Contribution 22.5 30.0 33%
Fixed costs 15.0 15.0 0%
EBIT 7.5 15.0 100%

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 Business risk
The riskier option offers greater
potential losses if sales volumes are low
and greater profits when sales volumes
are high.
Thus, total business risk is therefore a
function both sales and costs

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 Financial Risk
Financial Risk is due to financing with debt. Why?
Interest must be paid regardless of the performance of
the firm.
How do we measure financial risk?
Degree of Financial Leverage (DFL)

EBIT
DFL =
EBIT - I

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 Total company risk
Operating leverage and financial leverage work together to create what is referred to as
Degree of Combined Leverage (DCL)
The degree of combined leverage is

DCL = DOL x DFL

or
S-VC
DCL =
S-VC-F-I

Or DCL = Contribution/Net income before tax

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 Total company risk
Example from the Textbook
Leverhi Gearlow
S-VC 66.6 34.2
DOL = =
S-VC-F 33.3 27.9
= 2.0000 1.2258

EBIT 33.3 27.9

DFL = =
EBIT - I 27.0 27.0
= 1.2333 1.0333

DCL = DOL x DFL = 2.4667 1.2667

or
S-VC 66.6 34.2
DCL = =
S-VC-F-I 27.0 27.0
= 2.4667 1.2667 17
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