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BUSINESS RISK VERSUS FINANCIAL RISK

• Business risk:
• Uncertainty in future EBIT.
• Depends on business factors such as competition, operating leverage, etc.
• Financial risk:
• Additional business risk concentrated on common stockholders when
financial leverage is used.
• Depends on the amount of debt and preferred stock financing.
FINANCING RISK ( VARIABILITY IN EARNINGS
AND INSOLVENCY)

• Financial Structure
• Leverage
• Cost of Capital

Returns ( interest, dividend and growth)

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BUSINESS RISK

◼Uncertainty about future operating income

(EBIT). Probability
Low risk

High risk

0 E(EBIT) EBIT
◼Note that business risk focuses on operating
income, so it ignores financing effects.
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FACTORS THAT INFLUENCE BUSINESS RISK

• Uncertainty about demand (unit sales).

• Uncertainty about output prices.
• Uncertainty about input costs.
• Product and other types of liability.
• Degree of operating leverage (DOL).
 LEVERAGE

• The relative amount of the fixed cost of capital, principally debt, in a firm’s
capital structure to magnify returns to common equity
• Creates financial risk, which relates directly to the question of cost of
capital
• The more leverage, the higher then financial risk, and the higher the cost
of capital
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OPERATING LEVERAGE AND BUSINESS
RISK

• Operating leverage is the use of fixed costs rather than variable costs.
• The higher the proportion of fixed costs within a firm’s overall cost
structure, the greater the operating leverage.

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 • Higher operating leverage leads to more business risk, because a small
7 sales decline causes a larger profit decline.

P Rev. P Rev.
TC } Profit
TC
FC
FC

QBE Sales QBE Sales

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Use of debt increases shareholder returns
because of:

a. Positive financial leverage

- after tax ROA > Interest rate
- the higher the ROA or EBIT of given asset base is and the lower the
interest rate on debt is, the greater the benefits of financial leverage

b. Tax deductibility of interest payments

LEVERAGE

• Degree of operating leverage (DOL) – the percentage change in net

operating income or EBIT associated with a given percentage change
in sales
• Degree of financial leverage (DFL) – the percentage change in earnings
available to common shareholders that is associated with a given
percentage change in net operating income
• Degree of total leverage (DTL) – combines the DFL & the DOL
DEGREE OF OPERATING LEVERAGE

%  in EBIT CM
DOL = =
%  in sales EBIT
DEGREE OF FINANCIAL LEVERAGE

%  in net income EBIT

DFL = or
%  in EBIT EBIT - i -
P
Where
1 - t
net income is earnings available to common shareholders
i is interest expense
P is preferred dividend
t is tax rate
DEGREE OF TOTAL LEVERAGE

DTL = DFL x DOL or

% in net income CM
DTL = or
% in sales EBIT - i -
P
1-t
 Before After % Change
Sales 1,000 1,250 25%
VC 400 500
CM 600 750
FC 400 400
EBIT 200 350 75%
Interest 50 50
EBT 150 300
Tax (40%) 60 120
Net Inc 90 180
Pref Div 40 40
Inc - Com 50 140 180%
COMPUTATIONS
DEGREE OF OPERATING LEVERAGE

CM 600
DOL = = =3
EBIT 200
DOL x %Sales = %EBIT
3 x 25% = 75%
COMPUTATIONS
DEGREE OF FINANCIAL LEVERAGE

EBIT
DFL =
Pref Div
EBIT - int -
1- tax rate
200 200
= = =4
40 50
200 - 50 -
1 - 0.4
COMPUTATIONS
DEGREE OF FINANCING LEVERAGE

2.4 x 75% = 1.80

DFL x %EBIT = %Inc