Financial Risk

Financial risk is the additional risk placed on the common stockholders as a result of the decision to finance with debt. Conceptually, stockholders face a certain amount of risk that is inherent in a firm's operations—this is its business risk, which is defined as the uncertainty inherent in projections of future operating income. If a firm uses debt (financial leverage), this concentrates the business risk on common stockholders. To illustrate, suppose ten people decide to form a corporation to manufacture disk drives. There is a certain amount of business risk in the operation. If the firm is capitalized only with common equity, and if each person buys 10 percent of the stock, then each investor shares equally in the business risk. However, suppose the firm is capitalized with 50 percent debt and 50 percent equity, with five of the investors putting up their capital as debt and the other five putting up their money as equity. In this case, the five investors who put up the equity will have to bear all of the business risk, so the common stock will be twice as risky as it would have been had the firm been financed only with equity. Thus, the use of debt, or financial leverage, concentrates the firm's business risk on its stockholders. This concentration of

6See the Web Extension to this chapter for additional discussion of the degree of operating leverage.

See Ch 13 Tool Kit.xls for detailed calculations.

business risk occurs because debtholders, who receive fixed interest payments, bear none of the business risk.

To illustrate the concentration of business risk, we can extend the Strasburg Electronics example. To date, the company has never used debt, but the treasurer is now considering a possible change in the capital structure. For now, assume that only two financing choices are being considered—remaining at zero debt, or shifting to $100,000 debt and $100,000 book equity.

First, focus on Section I of Table 13-1, which assumes that Strasburg uses no debt. Since debt is zero, interest is also zero, hence pre-tax income is equal to EBIT. Taxes at 40 percent are deducted to obtain net income, which is then divided by the $200,000 of book equity to calculate ROE. Note that Strasburg receives a tax credit if the demand is either terrible or poor (which are the two scenarios where net income is negative). Here we assume that Strasburg's losses can be carried back to offset income earned in the prior year. The ROE at each sales level is then multiplied by the probability of that sales level to calculate the 12 percent expected ROE. Note that this 12 percent is the same as we found in Figure 13-2 for Plan B, since ROE is equal to ROIC if a firm has no debt.

Now let's look at the situation if Strasburg decides to use $100,000 of debt financing, shown in Section II of Table 13-1, with the debt costing 10 percent. Demand will not be affected, nor will operating costs, hence the EBIT columns are the same for the zero debt and $100,000 debt cases. However, the company will now have $100,000 of debt with a cost of 10 percent, hence its interest expense will be $10,000. This interest must be paid regardless of the state of the economy—if it is not paid, the company will be forced into bankruptcy, and stockholders will probably be wiped out. Therefore, we show a $10,000 cost in Column 4 as a fixed number for all demand conditions. Column 5 shows pre-tax income, Column 6 the applicable taxes, and Column 7 the resulting net income. When the net income figures are divided by the book equity —which will now be only $100,000 because $100,000 of the $200,000 total requirement was obtained as debt—we find the ROEs under each demand state. If demand is terrible and sales are zero, then a very large loss will be incurred, and the ROE will be —42.0 percent. However, if demand is wonderful, then ROE will be 78.0 percent. The probability-weighted average is the expected ROE, which is 18.0 percent if the company uses $100,000 of debt.

Typically, financing with debt increases the expected rate of return for an investment, but debt also increases the riskiness of the investment to the common stockholders. This situation holds with our example—financial leverage raises the expected ROE from 12 percent to 18 percent, but it also increases the risk of the investment as seen by the increase in the standard deviation from 14.8 percent to 29.6 percent and the increase in the coefficient of variation from 1.23 to 1.65.7

We see, then, that using leverage has both good and bad effects: higher leverage increases expected ROE, but it also increases risk. The next section discusses how this trade-off between risk and return affects the value of the firm.

What is business risk, and how can it be measured? What are some determinants of business risk? How does operating leverage affect business risk? What is financial risk, and how does it arise?

Explain this statement: "Using leverage has both good and bad effects."

7See Chapter 3 for a review of procedures for calculating the standard deviation and coefficient of variation. Recall that the advantage of the coefficient of variation is that it permits better comparisons when the expected values of ROEs vary, as they do here for the two capital structures.

TABLE 13-1 Effects of Financial Leverage: Strasburg Electronics Financed with Zero Debt or with $100,000 of Debt

SECTION I. ZERO DEBT

Debt 0

Book equity $200,000

Demand for

Pre-Tax

Taxes

Net

Product

Probability

EBIT

Interest

Income

(40%)

Income

ROE

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

Terrible

0.05

($ 60,000)

$0

($ 60,000)

($24,000)

($36,000)

-18.0 %

Poor

0.20

(20,000)

0

(20,000)

(8,000)

(12,000)

-6.0

Normal

0.50

40,000

0

40,000

16,000

24,000

12.0

Good

0.20

100,000

0

100,000

40,000

60,000

30.0

Wonderful

0.05

1 140,000

0

■ 140,000

1 56,000

1 84,000

1 42.0

Expected value:

$ 40,000

$0

$ 40,000

$16,000

$24,000

12.0 %

Standard deviation:

14.8 %

Coefficient of variation:

1.23

Assumptions: 1. In terms of its operating leverage, Strasburg has chosen Plan B. The probability distribution and EBITs are obtained from Figure 13-2.

2. Sales and operating costs, hence EBIT, are not affected by the financing decision. Therefore, EBIT under both financing plans is identical, and it is taken from the EBIT column for Plan B in Figure 13-2.

3. All losses can be carried back to offset income in the prior year.

Assumptions: 1. In terms of its operating leverage, Strasburg has chosen Plan B. The probability distribution and EBITs are obtained from Figure 13-2.

2. Sales and operating costs, hence EBIT, are not affected by the financing decision. Therefore, EBIT under both financing plans is identical, and it is taken from the EBIT column for Plan B in Figure 13-2.

3. All losses can be carried back to offset income in the prior year.

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