copyright: m. s. humayun1 financial management lecture no. 30 business risk faced by firm &...

Copyright: M. S. Humayun 1

Financial ManagementLecture No. 30

Business Risk faced by FIRM

& Operating Leverage (OL)

Breakeven Point & ROE

Prelude to Capital Structure


Debt vs EquityFrom FIRM’s Point of View

• Need Capital to Start a New Business or to Expand Operations

• Capital can be raised in basically 2 ways. Look at each from FIRM’S (or Company’s) Point of View:– Issuing Debt (or Leverage)

• Advantages of Issuing Debt: – Limited fixed Interest payment - no share in profits– Limited Life– Interest Payment is an Expense ie. Tax Deductible– Can Improve (or Amplify) the Return on Equity (ROE)

• Disadvantages– Debt adds to Company-specific Risk– If company doesn’t pay Interest, it can be closed down

– Issuing Equity (generally Common Equity or Ownership)• Advantages of Issuing Equity:

– Not required to pay fixed regular Dividends

• Capital Structure is a Firm’s Mix of Debt & Equity


Risks Faced by FIRM• Total Stand-Alone Risk of a STOCK (from Risk

and CAPM Theory).– Stock’s Total Stand Alone Risk = Diversifiable + Market– Company-specific Risk: Unique, Diversifiable– Market Risk: Systematic, Not Diversifiable

• Total Stand-Alone Risk of a FIRM (New)– Firm’s Total Stand Alone Risk = Business + Financial– Business Risk: Risk of All Assets & Operations

(without debt). Includes Both Company-Specific (or Diversifiable) & Market Risks.

– Financial Risk: Additional Risk faced by Common Stockholders if Firm takes Debt. Pure Debt-related Risk.


Financial Risk – ConceptINVESTOR’S Point of View

• Suppose Firm ABC had a Capital Structure of 100% Common Equity. Then the Management and Board of Directors of Firm ABC then decides to Reduce Half of the Equity and take a Loan (or Debt) instead. This affects the distribution of Risk & Return to the Common Equity holders (or Owners).– In other words, the Management of Firm ABC has added a New

Kind of Investor. The Debt Holder faces almost no risk because he is “guaranteed” the Interest payment at all costs whether or not the Firm is making profit or whether or not the Equity Owners are paid Dividend. Debt Holders eat away at the Owners’ (or Equity Holders’) money at almost no risk.

– So, naturally, the RISK faced by Equity Holders INCREASES because same Business Risk is now shouldered by Fewer Equity Shares. Risk per Share Increases. Generally Speaking, Increasing Debt Shifts More Risk Upon the Shareholders. Therefore REQUIRED ROR demanded by the Common Equity Holder also INCREASES (based on CAPM Theory)


Firm’s Total Stand Alone Risk Uncertainty in ROA & ROE

• Firm’s Total Stand Alone Risk measured by the Uncertainty or Fluctuations in Possible Outcomes for Firm’s Future Overall ROR.

• If Business has Debt & Equity (ie. LEVERED FIRM):– Firm’s Overall ROR = ROA = Return on Assets = Return to Investors /

Assets = (Net Income + Interest) / Total Assets– Note: Total Assets = Total Liabilities = Debt + Equity

• If Business is 100% Equity (or UN-LEVERED FIRM) No Debt and No Interest.– Firm’s Overall ROR = Net Income / Total Assets. For 100% Equity

Firm, Total Assets = Equity. So Overall ROR = Net Income / Equity = ROE ! Note: Net Income is also called Earnings.

– Note: ROE Does NOT Equal rE (Required Rate of Return). ROE is Expected Book Return on Equity. Used in Stock Valuation Formula to calculate “g” & “PVGO”

– Fluctuations in ROE = “Basic Business Risk”• Review Financial Accounting Ratios


Basic Business Risk(Not Considering Debt)

• Causes of High “Basic Business Risk” or Uncertainty or Volatility or “Instability” or “Shocks”– Large changes in Customers’ Demand (seasonality)– Unstable Selling Price (unstable markets and retailers)– Uncertainty in Input Costs (raw material, labor, utilities)– Inability of Management to Change Operational Tactics

and Strategy to Meet Changing Environment• Ineffective Price Stabilization• Poor Product R&D and Planning

– High Operating Leverage (OL)– Many other causes.


Operating Leverage (OL)• Formula:OL = Fixed Costs / Total Costs• Concept: High OL Increases Risk: Customer

Demand Falls but Fixed Costs remain High. So, Small Decline in Sales Can Cause Large Decline in ROE.

• Fixed Costs Across Different Industries:– Plant, Machinery, Equipment ie. Power Plant, Cement,

Steel, Textile Spinning– New Product Development, R&D Costs ie. Pharma,

Auto, IT– Highly Specialized & Skilled Workers ie. IT

• OL used in Capital Budgeting & Capital Structuring Decisions


Operating Leverage Application to Capital Budgeting

• Example: Comparing 2 Types of Technologies for Cement Manufacturing: (1) Wet Process and (2) Dry Process. Different Total & Fixed Costs, Different OL. – Applications to Capital Budgeting

• Different OL’s, Different Breakeven Points, Different Risks, Different Required ROR’s. So Different Discount Rates for 2 Technologies. Affects Computation of NPV Investment Criterion.

– Breakeven Point: Quantity of Sales at which EBIT = 0 therefore ROE = 0. EBIT = Op Revenue - Op Costs = Op Revenue - Variable Costs - Fixed Costs = PQ - VQ - F. Where P= Product Price (Rs), Q= Quantity or # Units Sold, V= Variable Cost (Rs), F= Fixed Cost (Rs). So IF EBIT = 0 then PQ-VQ-F = 0 so Breakeven Q = F / ( P - V )


Visualizing Operating Leverage (OL)Impact on Breakeven Point & Capital Budgeting

Total COST Line Technology A: Higher OL

Total COST Line Technology B

Sales Quantity (# of Units)

Revenues & Costs (Rupees)

Sales REVENUE Line

Fixed Costs A

Fixed Costs B

QB* QA

*

Breakeven A: Higher. More Risky

Technology A: Larger OPERATING LOSS (Cost > Revenue). More Risky


Operating Leverage Application to Capital Structure

• Applications to Capital Structure– Example of 2 Types of Cement Manufacturing

Technologies: Different OL’s has 2 Impacts: • Different Risks so Different Betas (CAPM

Approach to Cost of Equity Capital), Different WACC’s for 2 Technologies. Affects Choice of Capital Mix (or Capital Structure)

• Different Fixed Costs, Different EBIT & NI, Different ROE’s so Different Dividend Growth Rates “g,” (Gordon-Dividends Approach to Cost of Equity Capital). So Different WACC’s. Affects Choice of Capital Mix.


Visualizing Operating Leverage (OL)Impact on ROE & Capital Structure

Technology B: Lower OL: Low Risk & Low ROE

Technology A: High OL, High Risk & High ROE. Higher WACC

Pro

bab

ilit

y ( p

)

Return on Equity ( ROE)%

Risk B

Risk A

Expected ROE = <ROE>A

Expected ROE = <ROE>B


SML – WACC GraphSML Line (EXTERNAL MARKET criterion)

Firm’s own WACC (INTERNAL criterion)

Required ROR rCE (%)

Beta Risk

rRF = T-Bill rate

WACC1

23

FEASIBLE REGION (where IRR of investment or project is more than SML and WACC)

IRR <WACC < SML

IRR < SML

IRR < WACC

copyright: m. s. humayun1 financial management lecture no. 30 business risk faced by firm &...

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