Business risk and financial riskprofit per vessel falls below £100,000, however, the existence of debt finance weakens
the ordinary shareholder’s position. In fact, below a profit of £50,000 per vessel there
would be insufficient profit to cover the interest payments. Presuming that no other
assets exist, the business might have to dispose of one of the vessels to provide the
finance to meet the interest payments.
At virtually all levels of profit, the loan notes holders could view the situation
confidently. After all, not only do they have the legal right to enforce payment of their
interest and repayment of their capital; they even have the vessels as security. Only
if there were major losses to the market value of the yachts would the loan notes
holders’ position be seriously threatened.
Where gearing exists, the risk to which equity holders are exposed clearly is in-
creased over that which they would bear in the equivalent all-equity business. To
business risk, the normal risk attached to investing in the real world, is added finan-
cial risk, the risk caused by being burdened with the obligation to meet fixed finance
charges illustrated in Table 11.1.
Figure 11.1 depicts the relationship between business and financial risk where
operating returns fluctuate. The amount of business risk depends on the commercial
activities of the business; financial risk depends on how the business is financed.
Intuition and observation of the real world both tell us that risk and return are
related. Where investors perceive high risk, they require high returns. Hence, referring
back to the above example, while gearing will lift expected dividend per share to ordin-
ary shareholders from 14p to 18p, this will not necessarily increase the share price (and
therefore the wealth of the shareholder). Accompanying the increased expected divi-
dend is a wider range of possible outcomes (see Table 11.1).
Not all of the new possibilities that gearing brings to the returns to equity holders
are bad news. For example, for La Mer, Table 11.1 shows that for any chartering profit
per vessel above £100,000 p.a., ordinary share dividends would be enhanced. Most
investors, however, are risk-averse, which means that the possibility that profit per
vessel could be below £100,000 by a particular amount tends to be more significant to
them than the possibility that profits could be greater by the same amount.‘
‘Table 11.1Returns per share in La Mer plc for various levels of profit under each of two different
financial structures
(a) Annual profit per vessel 0 £50,000 £100,000 £150,000 £200,000All equity(b) Profit [(a) ×2] 0 £100,000 £200,000 £300,000 £400,000
(c) Return per share [ (b) ÷2,000,000] 0 £0.05 £0.10 £0.15 £0.2050% loan finance(d) Profit [(a) ×2] 0 £100,000 £200,000 £300,000 £400,000
(e)Less: Interest (£1 million @ 10%) £100,000 £100,000 £100,000 £100,000 £100,000
(f ) Net profit (£100,000) 0 £100,000 £200,000 £300,000
(g) Return per share [ (f ) ÷1,000,000] (£0.10) 0 £0.10 £0.20 £0.30