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Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?
Note that business risk does not include financing effects.
What is business risk?
Probability
EBITE(EBIT)0
Low risk
High risk
Factors That Influence Business Risk
Uncertainty about demand (unit sales).Uncertainty about output prices.Uncertainty about input costs.Product, other types of liability.Degree of operating leverage (DOL).
What is operating leverage, and how does it affect a firm’s business risk?
Operating leverage is the use of fixed costs rather than variable costs.
If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.
More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
Sales
$ Rev.TC
FC
QBE Sales
$ Rev.
TC
FC
QBE
Profit
What happens if variable costs change?
Probability
EBITL
Low operating leverage
High operating leverage
Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases.
EBITH
What is financial leverage?Financial risk?
Financial leverage is the use of debt and preferred stock.
Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.
Business Risk vs. Financial Risk
Business risk depends on business factors such as competition, product liability, and operating leverage.
Financial risk depends only on the types of securities issued: More debt, more financial risk. Concentrates business risk on stockholders.
How are financial and business risk measured in a stand-alone risk framework,
i.e., the stock is not held in a portfolio?
Stand-alone Business Financialrisk risk risk= + .
Stand-alone risk = ROE.
Business risk = ROE(U).
Financial risk = ROE - ROE(U).
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Consider 2 hypothetical firms
Both firms have same operating leverage, business risk, and probability distribution of EBIT. Differ only with respect to use of debt.
Firm U: Unleveraged
Prob. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400
Economy Bad Avg. Good
Firm L: Leveraged
Prob.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680
*Same as for Firm U.
Economy Bad Avg. Good
Firm U Bad Avg. GoodBEP* 10.0% 15.0% 20.0%ROI 6.0% 9.0% 12.0%ROE 6.0% 9.0% 12.0%TIE
Firm L Bad Avg. GoodBEP* 10.0% 15.0% 20.0%ROI 8.4% 11.4% 14.4%ROE 4.8% 10.8% 16.8%TIE 1.67x 2.5x 3.3x*BEP same for U and L.
8 8 8
Profitability Measures:
E(BEP) 15.0% 15.0%E(ROI) 9.0% 11.4%E(ROE) 9.0% 10.8%
Risk Measures:ROE 2.12% 4.24%CVROE 0.24% 0.39%E(TIE) 2.5x
U L
8
Conclusions
Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage.
L has higher expected ROI and ROE because of tax savings.
L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.
(More...)
In a stand-alone risk sense, Firm L is much riskier than Firm U.
L’s business risk is sROE(U) = 2.12%.L’s stand-alone risk is sROE = 4.24%.L’s financial risk is sROE - sROE(U) = 4.24%
- 2.12% = 2.12%. (U’s is zero.)
For leverage to raise expected ROE, must have ROA > kd(1 - T). (ROA = ROEU = 9%.)
Why? If kd(1 - T) > ROA, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress net income and ROE.
Capital Structure Theory
MM theoryTrade-off theorySignaling theoryDebt financing as a managerial
constraint
MM Theory
The effect of taxesThere is no tax on debt( bond).
The effect of bankruptcy costsThreat of bankruptcy from using
debt.
Trade-off between the use of debt (bond) and equity (preferred stock and common stock).
Trade-off between bankruptcy cost and the effect of tax
Trade-off theory
Symmetric information - same information
Asymmetric information - managers have better information than investors
Firms with favorable future - use debtFirms with poor prospects - use equity
Signaling theory