Chapter 13 Capital Structure and Leverage 40313-2 BUSINESS AND FINANCIAL RISK
In Chapter 8, we examined risk from the viewpoint of an individual investor and we
distinguished between risk on a stand-alone basis, where an asset’s cash " ows are ana-
lyzed by themselves, and risk in a portfolio context, where cash " ows from a number
of assets are combined and consolidated cash " ows are analyzed. In a portfolio con-
text, we saw that an asset’s risk can be divided into two components: diversi! able risk,
which can be diversi! ed away and hence is of little concern to most investors, and
market risk, which is measured by the beta coef! cient and re" ects broad market move-
ments that cannot be eliminated by diversi! cation and therefore is of concern to
investors. Then in Chapter 12, we examined risk from the viewpoint of the corpora-
tion and we considered how capital budgeting decisions affect the! rm’s riskiness.
Now we introduce two new dimensions of risk:
- Business risk, which is the riskiness of the! rm’s assets if no debt is used.
- Financial risk, which is the additional risk placed on the common stockholders
as a result of using debt.
13-2a Business Risk
Business risk is the single most important determinant of capital structure, and it
represents the amount of risk that is inherent in the! rm’s operations even if it uses
no debt! nancing. Consider Bigbee Electronics Company, a debt-free (unlevered)
! rm. Because the company has no debt, its ROE is equal to its ROA and either can
be used to estimate business risk. Figure 13-1 gives some clues about the company’s
business risk. The top graph shows the trend in ROE from 1998 through 2008; this
graph gives both security analysts and Bigbee’s management an idea of the degree
to which ROE has varied in the past and might vary in the future. The lower graph
shows the beginning-of-year subjectively estimated probability distribution of
Bigbee’s ROE for 2008 based on the trend line in the top section of Figure 13-1. As
the graphs indicate, Bigbee’s actual ROE in 2008 (8%) fell below the expected value
(12%); so the forecast had been too optimistic.
Bigbee’s past " uctuations in ROE were caused by many factors—booms and
recessions in the national economy, successful new product introductions by Big-
bee and by its competitors, labor strikes, and a! re in Bigbee’s main plant. Similar
events will doubtless occur in the future; and when they do, the realized ROE will
be higher or lower than the projected level. Further, there is always the possibility
that a long-term disaster will strike, permanently depressing the company’s earn-
ing power. For example, a competitor might introduce a new product that makes
Bigbee’s products obsolete and puts the company out of business. Automobiles
did this to buggy manufacturers about a century ago. The more uncertainty there
is about future ROEs, the greater the company’s business risk. Bigbee uses no debt,
so this is the risk its stockholders face. As we shall see, the stockholders face more
risk if the company chooses to! nance with both debt and equity.
Business risk varies from industry to industry and among! rms in a given in-
dustry. Further, business risk can change over time. For example, for many years,
the electric utilities were regarded as having little business risk; but a combination
of events in recent years altered the utilities’ situation, producing sharp declines in
their ROEs and greatly increasing the industry’s risk. Today food processors and
health care! rms are examples of industries with low business risk, while cyclical
manufacturing industries such as autos and steel, as well as many small start-up
companies, are regarded as having especially high business risks.^2
Business Risk
The riskiness inherent in
the firm’s operations if it
uses no debt.Business Risk
The riskiness inherent in
the firm’s operations if it
uses no debt.(^2) We have avoided any discussion of market versus company-speci! c risk in this section. We note now (1) that
any action that increases business risk in the sense of stand-alone risk will generally increase a! rm’s beta coe# -
cient and (2) that a part of business risk as we de! ne it will generally be company-speci! c and hence subject to
elimination as a result of diversi! cation by the! rm’s stockholders.