Fundamentals of Financial Management (Concise 6th Edition)

404 Part 5 Capital Structure and Dividend Policy

Business risk depends on a number of factors, the more important of which

are listed here:

1. Demand variability. The more stable the demand for a! rm’s products, other
   things held constant, the lower its business risk.


2. Sales price variability. Firms whose products are sold in highly volatile markets
   are exposed to more business risk than similar! rms whose output prices are
   more stable.


3. Input cost variability. Firms whose input costs are highly uncertain are exposed
   to a high degree of business risk.


4. Ability to adjust output prices for changes in input costs. Some! rms are better able
   than others to raise their own output prices when input costs rise. The greater
   the ability to adjust output prices to re" ect cost conditions, the lower the
   degree of business risk.


5. Ability to develop new products in a timely, cost-effective manner. Firms in high-
   tech industries such as drugs and computers depend on a constant stream of
   new products. The faster a! rm’s products become obsolete, the greater the
   ! rm’s business risk.


6. Foreign risk exposure. Firms that generate a high percentage of their earnings
   overseas are subject to earnings declines due to exchange rate " uctuations.

Bigbee Electronics: Trend in ROE, 1998–2008, and Estimated

F I G U R E 1 3! 1 Probability Distribution of ROE, 2008

0

10

20

• 10

2000 2002 2004 2006 2008

Actual 2008 ROE

2008 ROE as Projected

at Beginning of Year = 12%

ROE

(%)

a. Trend in Return on Equity (ROE)

Expected ROE

b. Subjective Probability Distribution of ROE for 2008

Probability

Density

0 8 12 ROE (%)

Actual ROE