RISK Whenever you make a financing or investment decision, there is some
RISK Whenever you make a financing or investment decision, there is some
uncertainty about the outcome. Uncertainty means not knowing exactly what will happen in the future. There is uncertainty in most everything we do as financial managers, because no one knows precisely what changes will occur in such things as tax laws, consumer demand, the economy, or interest rates.
Though the terms “risk” and “uncertainty” are often used to mean the same thing, there is a distinction between them. Uncertainty is not knowing what’s going to happen. Risk is how we characterize how much uncertainty exists: The greater the uncertainty, the greater the risk. Risk is the degree of uncertainty.
THE FUNDAMENTALS OF VALUATION
In financing and investment decisions there are many types of risk we must consider. These include:
■ Cash flow risk Business risk Sales risk Operating risk
Financial risk Default risk
■ Reinvestment risk Prepayment risk Call risk
■ Interest rate risk ■ Purchasing power risk ■ Currency risk
■ Portfolio risk Diversifiable risk Nondiversifiable risk
Let’s take a look at each of these types of risk. Cash Flow Risk
Cash flow risk is the risk that the cash flows of an investment will not materialize as expected. For any investment, the risk that cash flows may not be as expected—in timing, amount, or both—is related to the investment’s business risk.
Business Risk Business risk is the risk associated with operating cash flows. Operating
cash flows are not certain because neither are the revenues nor the expenditures comprising the cash flows.
Revenues: depending on economic conditions and the actions of competitors, prices or quantity of sales (or both) may be different from what is expected. This is sales risk. Expenditures: operating costs are comprised of fixed costs and variable costs. The greater the fixed component of operating costs, the less easily a company can adjust its operating costs to changes in sales.
The mixture of fixed and variable costs depends largely on the type of business. For example, fixed operating costs make up a large portion of an airline’s operating costs: No matter how many passengers are fly-
Risk and Expected Return
ing, the airline still needs to pay gate fees, pay a pilot, and buy fuel. The variable costs for an airline—the costs that change depending on the number of passengers—amount to a little bit of fuel and the cost of the meal.
Even within the same line of business, companies can vary their fixed and variable costs. For example, an airline could develop a system that allows it to vary the number of cabin stewards and baggage han- dlers according to passenger traffic, varying more of its operating costs as demand changes.
We refer to the risk that comes about from the mix of fixed and variable costs as operating risk. The greater the fixed operating costs relative to variable operating costs, the greater the operating risk.
Let’s take a look at how operating risk affects cash flow risk. Remember back in economics when you learned about elasticity? That’s
a measure of the sensitivity of changes in one item to changes in another. We can look at how sensitive a firm’s operating cash flows are to changes in demand, as measured by unit sales. We’ll calculate the operating cash flow elasticity, which we call the degree of operating leverage (DOL).
The degree of operating leverage is the ratio of the percentage change in operating cash flows to the percentage change in units sold. Let’s simplify things and assume that we sell all that we produce in the same period. Then,
Percentage change in operating cash flows DOL = -------------------------------------------------------------------------------------------------------------
Percentage change in units sold Suppose the price per unit is $30, the variable cost per unit is $20,
and the total fixed costs are $5,000. If we go from selling 1,000 units to selling 1,500 units, an increase of 50% of the units sold, operating cash flows change from:
1,000 Units Sold 1,500 Units Sold
Less variable costs
Less fixed costs
Operating cash flow
Operating cash flows doubled when units sold increased by 50%. What if the number of units decreases by 25%, from 1,000 to 750?
THE FUNDAMENTALS OF VALUATION
1,000 Units Sold 750 Units Sold
Less variable costs
Less fixed costs
Operating cash flow
Operating cash flows decline by 50%. For any 1% change in units sold, the operating cash flow changes by 2%, in the same direction. So if units sold increased by 10%, operating cash flows would increase by 20%; if units sold decreased by 10%, operating cash flows would decrease by 20%.
We can represent the degree of operating leverage in terms of the basic elements of the price per unit, variable cost per unit, number of units sold, and fixed operating costs. Operating cash flows are:
Operating cash flow = ( Price per unit ) Number of units sold ( ) – ( Variable cost per unit ) Number of units sold ( ) – ( Fixed operating costs )
How much do operating cash flows change when the number of units sold changes? It changes by the difference between the price per unit and the variable cost per unit—called the contribution margin—times the change in units sold. The percentage change in operating cash flows for a given change in units sold is:
Number Price Variable of units per – cost
unit per unit DOL = -------------------------------------------------------------------------------------------------------------
sold
(10-1) Number Price Variable Fixed
of units per – cost
– operating
sold
unit per unit costs Applying the formula for DOL using the data in the example, we
can figure out the sensitivity to change in units sold from 1,000 units:
---------------------------------------------------------------------- 1,000 $30 $20 ( – DOL for 1,000 units ) = = 2
A DOL of 2.0 means that a 1% change in units sold results in a 1% ×
2.0 = 2% change in operating cash flow.
Risk and Expected Return
Why do we specify that the DOL is at a particular quantity sold (in this case 1,000 units)? Because the DOL will be different at different numbers of units sold. For example, at 10,000 units,
-------------------------------------------------------------------------- 10,000 $30 $20 ( – DOL for 10,000 units ) = = 1.05
Let’s look at situation in which the firm has shifted some of the oper- ating costs away from fixed costs and into variable costs. Suppose the firm has a unit sales price of $30, a variable cost of $24 a unit, and $1,000 in fixed costs. A change in units sold from 1,000 to 1,500—a 50% change—changes operating cash flows from $5,000 to $8,000, or 60%:
1,000 Units Sold 1,500 Units Sold
Less variable costs
Less fixed costs
Operating cash flow
DOL at 1,000 units =
and
Percentage change inoperating cash flows = DOL Percentage change in units sold ( ) =
( 1.2 50% ) = 60% What we see in our calculations here is what we saw a bit earlier in
our reasoning of fixed and variable costs: The greater use of fixed, rela- tive to variable operating costs, the more sensitive operating cash flows are to changes in units sold and, therefore, more operating risk.
At 1,000 units produced and sold, we see that the DOL is 2.0; at 10,000 units, the DOL is 1.2. The degree of operating leverage is sensi- tive to the number of units produced and sold.
We can gain additional insight into the firm’s profitability and its uncertainty by looking at the relation between profitability and the number of units produced and sold. What number of units must be pro- duced and sold to just break even (that is, to just cover the fixed operat-
THE FUNDAMENTALS OF VALUATION
ing costs)? The answer to this question is found by rearranging the operating cash flow equation:
$0 = ( Price per unit ) Number of units sold ( ) – ( Variable cost per unit ) Number of units sold ( ) – ( Fixed operating costs )
The break-even number of units, Q BE , is: ( Fixed operating costs )
Q BE = -----------------------------------------------------------------------------------------------------
(10-2)
( Price per unit Variable cost per unit – )
Consider the example in which fixed operating costs are $5,000, price per unit is $30, and variable cost per unit is $20. The break-even quantity is:
$5,000 Q BE = ------------------------------ = 500 units
If the firm produces and sells 500 units, there are no operating profits and the DOL is undefined.
Both sales risk and operating risk influence a firm’s operating cash flow risk. And both sales risk and operating risk are determined in large part by the type of business the firm is in. But management has more opportunity to manage and control operating risk than they do sales risk.
Suppose a firm is deciding on which equipment to buy to produce a particular product. The sales risk is the same no matter what equipment is chosen to produce the product. But the available equipment may dif- fer in terms of fixed and variable operating costs of producing the prod- uct. Financial managers need to consider the operating risk associated with their investment decisions.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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