Business Risk - Financial Management

Two elements of risk are primary considerations in the capital structure decision: the business risk and the financial risk of a firm. Financial risk is discussed in the following section.

Business risk refers to the variability or uncertainty of a firm’s operating income (EBIT). Many factors influence a firm’s business risk (holding constant the effects of all other important factors), including

  1. The variability of sales volumes over the business cycle. Firms, such as Delta Air Lines, whose sales tend to fluctuate greatly over the business cycle have more business risk than firms such as Lowe’s Companies. For example, 2004, financial analysts were forecasting that Lowe’s would have record high sales and earnings. In contrast, analysts were expecting Delta Air Lines to have substantial losses in 2004.
  2. The variability of selling prices. In some industries, prices are quite stable from year to year, or the firm may be able to increase prices regularly over time. This is true for many consumer products, such as brand -name prepared food items (e.g., Kraft cheese, Nabisco cookies). In contrast, in other industries, price stability is much less certain. For example, over the past two decades, the oil companies, such as Exxon Mobil and Shell Oil, have learned important lessons about the instability of prices as the price of crude oil declined from more than $30 a barrel to less than $10 a barrel only to return recently to nearly $40 a barrel. Generally, the more price-competitive an industry is, the greater is the business risk for firms in that industry.
  3. The variability of costs. The more variability there is in the cost of the inputs used to produce a firm’s output, the greater is the business risk of that firm. For example, airline companies, such as Delta, American, and United, have been affected significantly by the volatility in the price of jet fuel.
  4. Existence of market power. Firms, such as General Electric, that have greater market power because of their size or the structure of the industries in which they compete often have a greater ability to control their costs and the price of their outputs than firms operating in a more competitive market environment. Therefore, the greater a firm’s market power, the less its business risk. When evaluating a firm’s market power, it is often useful to consider not only the current competition facing the firm but also potential future competition, especially competition that might develop from abroad.
  5. The extent of product diversification. All other things held constant, the more diversified a firm’s product line, the less variable its operating income is likely to be. For example, IBM offers a broad array of products and services, including computer chips, personal computers, mid -range computers, large mainframe computers, computer software and systems, and financing. When demand for one of its products or services falters, this can be offset by sales in other areas. In contrast, Advanced Micro Devices primarily produces integrated circuits for the computer industry. It has experienced great volatility in operating earnings over time as demand for its limited product line has fluctuated.
  6. The level and rate of growth. Rapidly growing firms, such as, often experience great variability in their operating earnings. Rapid growth causes many stresses on the operations of a firm. New facilities must be constructed, often possessing uncertain operating cost characteristics; internal control systems must be expanded and updated; the pool of managerial talent must be increased rapidly; and new products require expensive research and development outlays. These factors often combine to result in high variability of operating income.
  7. The degree of operating leverage (DOL). Operating leverage involves the use of assets having fixed costs. The more a firm makes use of operating leverage, the more sensitive EBIT will be to changes in sales. The degree of operating leverage is the multiplier effect resulting from a firm’s use of fixed operating costs.

    The DOL is defined as the percentage change in EBIT resulting from (divided by) a given percentage change in sales (output).Thus, if a firm is subject to considerable sales volatility over the business cycle, the variability of EBIT (business risk) can be reduced by limiting the use of assets having fixed costs in the production process. Similarly, if a firm’s sales tend to be stable over the business cycle, using a high percentage of fixed -cost assets in the production process will have little impact on the variability of EBIT.

    In a sense, the business risk of a firm is determined by the accumulated investments the firm makes over time. These investments determine the industries in which a firm will compete, the amount of market power the firm will possess, and the extent of fixed costs in the production process.

    Firms in consumer products industries, such as grocery retailing (Albertsons, for example), brewing (Anheuser -Busch), food processing (Kraft Foods), and electric (Duke Energy) and natural gas distribution (Piedmont Natural Gas) utilities, tend to have low levels of business risk. In contrast, firms in durable goods manufacturing (DaimlerChrysler), industrial goods manufacturing (USX-US Steel), and airlines (Delta Air Lines) tend to have higher levels of business risk.

Business Risk: Systematic or Unsystematic Risk?

Business risk possesses elements of both systematic risk and unsystematic risk. Some of the variability in operating income that results from business risk cannot be diversified away by investors who hold a broad -based portfolio of securities. For example variability attributable to business cycle behavior is clearly systematic. In contrast, the variability attributable to specific managerial decisions, such as product line diversity, is primarily unsystematic. When analysts attempt to assess the specific total risk of a firm, they must consider both systematic and unsystematic components of that risk.

A firm may encounter operating (and financial) difficulty because of both economy -wide factors that impact its operations and because of unique decisions made by its management.

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