BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY

<< WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas

OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK >>

Financial Management MGT201

Lesson 30

BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT&

RETURN ON EQUITY

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following topics

· Business Risk faced by FIRM

· Operating Leverage (OL)

· Breakeven Point & ROE

In this lecture, we are going to continue our discussion on weighted average cost of capital and we

will begin our discussion on the concept of operating leverage. Both of these concepts are of the area

which we have stated in the previous lecture called capital structure.

In capital structure we decide what the distribution of debt and equity should be in the firm and it

is decided by the board of directors of the firm or company. The job of deciding what amount of debt

and equity one has is difficult.

So, the first thing is to calculate the cost of capital. so, the company has the option that it may

either go into money market or into the capital market to raise money either through debt or through

equity . Now, you might think the equity the company might raise has no cost. We all know that when a

company takes a loan it has to pay interest or mark up on it but often people think when it raise fund

through equity in stock exchange then there is no cost attached to it because they are not paying any

fixed rate of interest with regular intervals .but that is mistake because there is cost attached to it in form

of required rate of return which your stock holder expects to receive that and if company does not pay

that then the stock holder will sell their shares and the price of the share will go down .Therefore it is

important to calculate the cost of equity.

Now, let's combine all the cost associated with the debt, preferred stock and equity and

calculate the weighted average cost of capital (WACC) of company that raise capital in all three

possible ways.

Example:

Suppose company ABC has equal amounts of debts, common stocks and preferred equity 1/3

each .in previous lecture, we calculated what the cost of debt was that was 11.2% then we calculated the

cost of preferred equity that was 16.7% and we also calculated the cost of common equity which was

22.7% it was the most difficult part of the WACC calculation now, it is easy because we are to apply

the %of three different forms of capital.

WACC= rDxD+rExE+rPEp

=11.2 %( 1/3) +16.5 %( 1/3) +22.7 %( 1/3)

=16.9%

Now, this is over all cost for a company .what does it mean? It means that it is the average cost

that company has to bear in order to use the capital of investors. The cost of debt or bond, preferred

equity and common stock this is the average of all three securities cost.

It means that the company should invest in a project where the rate of return is higher than

16.9% because it should be higher than the cost that it has to pay to the investors. Let's see the graph of

weighted average cost of capital compared to the security market line we discussed in capital asset

pricing model (CAPM).

It is important to understand this graph because it combines the market factors in the form of

SML as well as the company's internal cost in the form of WACC. It shows that what combinations of

the risk & return for a particular company to invest in or not.

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Financial Management MGT201

SML WACC Graph

Required

FEASIBLE REGION (where

SML Line

ROR rCE (%)

IRR of investment or

(EXTERNAL

project is more than SML

MARKET

and WACC)

criterion)

IRR < SML

WACC

Firm's own

WACC

IRR < WACC

(INTERNAL

rRF = T-

IRR <WACC < SML

criterion)

Bill rate

Beta Risk

The graph is a combine presentation of CAPM and WACC.it shows the expected return against

the market risk or beta. In graph, the upward sloping line is SML and it is the requirement for bond and

stocks in efficient markets where there are rational investors that are maintaining fully diversified

portfolio and where knowledge spread very quickly through the markets. The risk and return

combinations of all securities should lie on SML. The horizontal line is WACC which is fixed at 16.9%

we have just calculated it .This represents required rate of return. In other words, if the company invests

in any new project it should give a rate of return which is higher than 16.9% you see that the only

feasible reason where that company made investment is the area which I have shown filled up with dots

and this is higher then the SML and WACC. I have also made three crosses which represents that why

will not company invest in these areas? The first cross on right side X1 is showing rate of return which

is higher than WACC but lower than SML the company will not invest because it is not giving as much

rate of return as efficient market is offering .The second cross x2 is lower than WACC and SML and

cross three x3 is lower than WACC but it is on the SML again the company will not invest in these two

projects or regions.

It will invest only in dots regions on these two regions the cost is higher and the return is lower.

Debt

Equity

from Firm's Point of View

Remember, that it is mentioned that generally speaking companies want to keep the balance

both in form of debt and equity. We have also mentioned that debt has a risk attached with it because

when we have to service the regular loan mark up or interest which will eat away your income and the

result will be net loss. you know that in income statement we deduct certain financial charges .it may be

due to many reasons because the company has to serve the debt .the other reason is that if the company

do not pay interest it may close down so, then why do companies take debt ?

Issuing Debt (or Leverage)

Advantages of Issuing Debt::

Limited fixed Interest payment - no share in profits

Limited Life

Interest Payment is an Expense i.e. 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)

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Financial Management MGT201

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:

It is defined as the Risk of All Assets & Operations (without debt). Includes both

Company-Specific (and Diversifiable) & Market Risks.

Financial Risk:

Additional Risk faced by Common Stockholders if Firm takes Debt. It is a pure debt-

related Risk.

Financial Risk (Investor'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 decide 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 (i.e. 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"

You should review Financial Accounting Ratios for better understanding of the above mentioned

concepts.

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)

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Financial Management MGT201

Many other causes

Operating Leverage (OL):

Formula = 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 i.e. Power Plant, Cement, Steel, Textile Spinning

New Product Development, R&D Costs i.e. Pharma, Auto, IT

Highly Specialized & Skilled Workers i.e. 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

Revenues &

Sales REVENUE Line

Costs (Rupees)

Total COST Line

Technology A:

Technology A: Larger

Higher OL

OPERATING LOSS

(Cost > Revenue).

Total COST Line

More Risky

Technology B

Fixed Costs A

Breakeven A: Higher.

More Risky

Fixed Costs B

Sales Quantity

(# of Units)

Operating Leverage Application to Capital Structure

Applications to Capital Structure

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Financial Management MGT201

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:

Pro

Low Risk & Low ROE

bab

ility

Technology A: High OL,

(p)

High Risk & High ROE.

Risk B

Higher WACC

Risk A

Expected ROE

= <ROE>B

= <ROE>A

Return on Equity (ROE) %

Now, let's talk in more detail about the operating leverage .in financial management the term leverage

refers to the little change in the amount of sales or quantity of sale that will affect the over all earning of

the company .

Operating leverage (OL)

=FIXED COSTS /TOTAL COSTS

A company supposes has operating leverage of suppose 50% or 0.5 it is considered to a high leverage.

Generally, it is more risky for a firm and the fixed cost does not change. So, the companies that has high

leverage are considered to be more risky .Now, the companies have to hire the skilled people and

technicians specially ,in the capital intensive industries .now, let's talk about the operating

leverage .let's take the example of cement industry there are two ways of technology if you want to set

a cement plant one is the old technology and the other is drying process new technology .these two

types have different costs .we have learnt that NPV formula is best for investment decisions in which

discount rate r is used which is the required rate of return .when OL associated with a firm is higher

then the risk also becomes higher .we need to understand the impact of operating leverage both

numerically ,and graphically .please go over the concepts of WACC and NPV.

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