Business and Financial Risk

When we examined risk from the viewpoint of the individual investor, we distinguished between risk on a stand-alone basis, where an asset’s cash flows are analyzed by themselves, and risk in a portfolio context, where the cash flow’s from a number of assets are combined and then the consolidated cash flows are analyzed. In a portfolio context, we saw that an asset’s risk can be divided into two components: diversifiable risk, which can be diversified away and hence is of little concern to most investors, and market risk, which is measured by the beta coefficient and which reflects broad market movements that cannot be eliminated by diversification and therefore is of concern to all investors. We examined risk from the viewpoint of the corporation, and we considered how capital budgeting decisions affect the firm’s riskiness.

Now we introduce two new dimensions of risk:

1. Business risk, which is the riskiness of the firm’s assets if it uses no debt.

2. Financial risk, which is the additional risk placed on the common stockholders as a result of the decision to use debt.

Business Risk

Business risk is defined as the uncertainty inherent in projections of future returns on assets (ROA), and t is the single most important determinant of capital structure. Consider Bigbee Electronics Company, a firm that currently uses 100 percent equity. Since the company has no debt, its ROE moves in lock-step with its ROA, and either ROE or ROA can be examined to estimate business risk. Figure 13-1 gives some clues about Bigbee’s business risk. The top graph shows the trend in ROE (and ROA) from 1987 through 1997; this graph gives both security analysts and Bigbee’s management an idea of the extent to which ROE has varied in the past and might vary in the future. The bottom graph shows the beginning-of-year, subjectively estimated probability distribution of Bigbee’s ROE for 1997 based on the trend line in the top section of Figure 13-1. The estimate was made at the beginning of 1997, and the expected 12 percent was read from the trend line. As the graphs indicate, the actual ROE in 1997 (8%) fell below the expected value (12%).

Bigbee’s past fluctuations in ROE were caused by many factors-booms and recessions in the national economy, successful new products introduced both by Bigbee and by its competitors, labor strikes, a fire in Bigbee’s major plant, and so on. Similar events will doubtless occur in the future, and when they do, ROE will rise or fall. Further, there is always the possibility that a long-term disaster will strike, permanently depressing the company’s earning power. For example, a competitor might introduce a new product that would permanently lower Bigbee’s earnings.² Uncertainty about Bigbee’s future ROE is the company’s basic business risk.

Business risk varies from one industry to another and also among firms in a given industry. Further, business risk can change over time. For example, the electric utilities were regarded for years as having little business risk, but the introduction of competition in recent years altered their situation, producing sharp declines in ROE for some companies and greatly their situation. Producing sharp declines in ROE for some companies and greatly increasing the industry’s business risk. Today, food processors and grocery retailers are frequently cited as examples of industries with low business risk. Whereas cyclical manufacturing industries such as steel are regarded as having relatively high business risk. Smaller companies, especially single product firms, also have relatively high business risk.³

Business risk depends on a number of factors, including the following:

1. Demand (unit sales) variability. The more stable a firm’s unit sales, other things held constant, the lover its business risk. The amount of competition a firm face is a factor here:

2. Sales price variability. Firms whose products are sold in highly volatile markets are exposed to more business risk than similar firms whose output prices are relatively stable. Again, the amount of competition faced is important.

3. Input price variability. Firm whose input costs. Including product development costs, are highly uncertain are exposed to high business risk.

4. Ability to adjust output prices for changes in input prices. Some firms have little difficulty in raising their own output prices when input costs rise, and the greater the ability to adjust output prices, the lower the business risk. This factor is especially important during periods of high inflation.

5. The extent to which costs are fixed: operating leverage. If a high percentage of costs are fixed, hence do not decline when demand decreases, this increases the company’s business risk. This factor is called operating leverage, and it is discussed at length in the next section.

Each of these factors in influenced by the firm’s industry characteristics, but each is also controllable to some extent by management. For example, many firms can through their marketing policies, take actions to stabilize both unit sales and sales prices. However, such stabilization may require either large expenditures on advertising or price concessions to induce customers to commit to purchase fixed quantities at fixed prices in the future. Similarly, firms such as Bigbee Electronics can reduce the volatility of future input costs by negotiating long-term labor and materials supply contracts, but they may have to agree to pay prices above the current market price to obtain these contracts.⁴