Financial Risk When we refer to the cash flow risk of a security, we expand our con-

Financial Risk When we refer to the cash flow risk of a security, we expand our con-

cept of cash flow risk. Since a security represents a claim on the income and assets of a business, the risk of the security is not just the risk of the cash flows of the business, but also the risk related to how these cash flows are distributed among the claimants—the creditors and owners of the business. Therefore, cash flow risk of a security includes both its business risk and its financial risk.

Financial risk is the risk associated with how a company finances its operations. If a company finances with debt, it is a legally obligated

Risk and Expected Return

to pay the amounts comprising its debts when due. By taking on fixed obligations, such as debt and long-term leases, the company increases its financial risk. If a company finances its business with equity, either gen- erated from operations (retained earnings) or from issuing new equity, it does not incur fixed obligations.

The more fixed-cost obligations (i.e., debt) incurred by the firm, the greater its financial risk. We can quantify this risk somewhat in the same way we did for operating risk, looking at the sensitivity of the cash flows available to owners when operating cash flows change. This sensi- tivity, which we refer to as the degree of financial leverage (DFL), is:

Percentage change in cash flows to owners DFL = --------------------------------------------------------------------------------------------------------------

Percentage change in operating cash flows The cash flows to owners are equal to operating cash flows, less

interest and taxes. If operating cash flows change, how do cash flows to owners change? Suppose operating cash flows change from $5,000 to $6,000 and suppose the interest payments are $1,000 and, for simplicity and wishful thinking, the tax rate is 0%:

Operating Cash Flow Operating Cash Flow

of $5,000

of $6,000

Operating cash flow

$6,000 Less interest

1,000 Cash flows to owners

A change in operating cash flow from $5,000 to $6,000—a 20% increase—increased cash flows to owners by $1,000—a 25% increase. What if, instead, our fixed financial costs are $3,000? A 20% change in operating cash flows results in a 50% change in the cash flows available to owners:

Operating Cash Flow Operating Cash Flow

of $5,000

of $6,000

Operating cash flow

$6,000 Interest

3,000 Cash flows to owners

$3,000 Using more debt financing increases the sensitivity of owners’ cash flows.

We can write the sensitivity of owners’ cash flows to a change in operating cash flows as:

THE FUNDAMENTALS OF VALUATION

 Number  Price  Variable   Fixed    of units   per – cost

  operating   sold

  unit per unit   costs  DFL = ------------------------------------------------------------------------------------------------------------------------------------------------- (10-3)

 Number  Price  Variable   Fixed   Fixed   of units   per – cost

  unit per unit   costs   costs 

If Number of units sold = 1,000

Price per unit

Variable cost per unit = $20 Fixed operating costs = $5,000 Fixed financing costs = $1,000

DFL for 1,000 units = ----------------------------------------------------------------------------------------------- = 1.25

1,000 $30 $20 ( – ) $5,000 – – $1,000 Again, we need to qualify our degree of leverage by the level of produc-

tion since DFL is different at different levels operating cash flows. The firm must produce and sell a sufficient number of units to make

a profit for owners. How many units are necessary? The answer is simi- lar to what we did for the break-even in terms of operating profits, but this time we have to also cover the fixed financial costs (that is, interest). The break-even number of units considering both operating and finan-

cial costs, indicated as Q * BE , is:

Q * = ( Fixed operating costs ----------------------------------------------------------------------------------------------------------------------------- ) + ( Fixed financing costs ) BE (10-4)

( Price per unit Variable cost per unit – )

In other words, the firm must produce and sell more than Q * BE units to make a profit. In our example, the break-even number of units, with total fixed costs of $6,000, is:

Q BE * = ------------------------------ $6,000 = 600 units ( $30 $20 – )

If the firm sells 600 units, profits to owners will be zero. If the firm sells less than the 600 units, the firm has a loss and if the firm sells more than the 600 units, the firm has a profit. 1

1 If the firm produces and sells exactly 600 units, the DFL is undefined.

Risk and Expected Return

The greater the use of financing sources that require fixed obliga- tions, such as interest, the greater the sensitivity of cash flows to owners to changes in operating cash flows.