Business and Financial Risk 481
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 firms are bet-
ter able than others to raise their own output prices when input costs rise. The
greater the ability to adjust output prices to reflect cost conditions, the lower the
business risk.
5.Ability to develop new products in a timely, cost-effective manner.Firms in
such high-tech industries as drugs and computers depend on a constant stream of
new products. The faster its products become obsolete, the greater a firm’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 fluctuations. Also, if
a firm operates in a politically unstable area, it may be subject to political risks. See
Chapter 15 for a further discussion.
7.The extent to which costs are fixed: operating leverage.If a high percentage of
its costs are fixed, hence do not decline when demand falls, then the firm is exposed
to a relatively high degree of business risk. This factor is called operating leverage,
and it is discussed at length in the next section.
Each of these factors is determined partly by the firm’s industry characteristics, but
each of them is also controllable to some extent by management. For example, most
0
10
20
1994 1996 1998 2000 2002
Actual 2002 ROIC
2002 ROIC as Projected
at Beginning of Year = 12%
ROIC
(%)
a. Trend in Return on Invested Capital (ROIC)
Expected ROIC
b. Subjective Probability Distribution of ROIC for 2002
Probability
Density
0 8 12 ROIC (%)
Actual ROIC
FIGURE 13-1 Strasburg Electronics: Trend in ROIC, 1992–2002, and
Subjective Probability Distribution of ROIC, 2002
Capital Structure Decisions 477
