FREE online courses on Capital Structure of Firms - Business vs. Financial Risk
We have discussed that the risk a firm faces is known as the total risk. However, since the firm is technically owned by its shareholders, they are more interested in the firm's market risk (i.e. non diversifiable risk) because they can eliminate the diversifiable risk through diversification. We have discussed this concept when we looked at a project's stand-alone risk versus its market risk. Similarly, the shareholders are more interested in the project's market risk than its stand-alone risk.
At this point in time, it is beneficial for us to go back and focus on a firm's total risk. Since we are focusing on the common stockholders, we will use the volatility of the firm's return on equity (ROE) to represent the firm's total risk. If you remember, the ROE of a firm is represented as follows:
A firm's total risk can be broken down into different components such as default risk, inflation risk, exchange rate risk, etc. We will focus only on two of those risks: (1) business risk (which focuses on a firm's operations), and (2) financial risk (which focuses on a firm's financing decisions).
A firm's business risk represents the uncertainty of the firm's return on its assets. In other words, this is the inherent risk in doing business. The business risk of a firm can be represented by the volatility of its return on asset (ROA):
Since the firm's assets must be equivalent to the amount of investment made, the ROA can be written as the return on investment (ROI):
In the situation where the firm uses no debt (i.e. an unleveled firm), the ROA of the firm becomes its return on equity (ROE):
We will use the volatility of the ROE to represent a firm's business risk. In other words, we will focus our attention on an unleveled firm. The reason for doing that is to extract the influence of a firm's financing decision (i.e. its capital structure), and focus solely on the factors affecting the firm's operation. There are many factors affecting a firm's business risks:
(a) Demand variability
(b) Sales price variability
(c) Input cost variability
(d) Ability to adjust output prices for changes in input costs
(e) Ability to develop new products in a timely, cost-effective manner
(f) Operating leverage: a firm's ratio of fixed cost relative to its variable cost
Any of the factors listed above will have an impact on a firm's net income and hence its business risks. The bigger the impact, the higher the firm's business risks.
So far, we have focus our attention on an unleveled firm and realized that the firm's business risk is represented by the volatility of its ROE as a result of its uncertain operation. However, most of firms are not financed entirely with equity, but with a combination of debt and equity. We need to look at how a firm's financial leverage (i.e. using debt) affects its ROE.
It is assumed that you have discussed the concept of financial leverage in Introductory Business Finance. If you remember, when a firm goes from solely equity financing to a mixture of debt and equity financing, the firm's ROE becomes more volatile. Hence, a firm's financial risk represents the impact of a firm's financing decision (or capital structure) on its ROE.
Why does the usage of debt instruments make a firm riskier to common stockholders? When a firm issues debt (i.e. financial leverage), it takes on additional responsibility of financing the debt (i.e. paying interest payments on time). The inability of the firm to pay the interest payments (or repay the principal) will result in a default that might lead to bankruptcy. As the amount of debt used by the firm increases, the chances of it defaulting will also go up (due to more constraints on its cash flows as a result of the interest payments).
It is important to remember that the common stockholders have the last claim on the firm's asset. As the amount of debt issued by the firm increases, more of the assets will be used to pay off the debt holders before they are divided among the common stockholders. We know that financial leverage increases the shareholders' expected returns, but it also increases the volatility of those returns. Does the increase in the expected returns sufficiently compensate the shareholders for the increase in risk? We need to turn to capital structure theory to help shed some light on this question.