Risk and Risk Balancing: What are the Risks and How Can I Manage Them?
Types of Risk 1.Business/operations Price, yield – ROA 2.Financial Debt load and cost – ROE
Principle of Increasing Risk The tendency for total risk to become greater at an increasing rate as the relative amount of nonequity capital in the business increases.
Principle of Increasing Risk nonequity capital / assets Equity Capital$200,000 Nonequity Capital0200,000400,000 Total Capital$200,000$400,000$600,000 Income when ROA is 15% Returns to Capital Used$30,000$60,000$90,000 Cost of nonequity capital (9%)018,00036,000 Total return on equity capital$30,000$42,000$54,000 ROE15%21%27% Income when ROA is -15% Returns to Capital Used($30,000)($60,000)($90,000) Cost of nonequity capital (9%)018,00036,000 Total return on equity capital($30,000)($78,000)($126,000) ROE-15%-39%-63%
Risk Balancing Concept Total Risk = business/operating risk x financial risk Business/Operating Risk Financial Risk To safely borrow more money you need to manage business/operating risk. To safely borrow more money you need to manage business/operating risk.
Best Capital Structure More debt reduces total cost of capital, increases return More debt increases risk How much risk are you willing to take to get more return?
Summary Risk increases rapidly as leverage increases, but debt is less expensive than equity To reduce total risk, must manage operating risk when borrowing money
Strategic Business Planning for Commercial Producers