Video Transcript: Financial Risk and Financial Leverage

Hello, welcome. We're going to discuss financial risk and financial leverage.  Financial Risk is the additional risk placed on the common stockholders as a  result of the decision to finance with debt. Conceptual, conceptually,  stockholders face a certain amount of risk that is inherent in a firm's operation.  This is its business risk, which is defined as the uncertainty and projections of  future EBIT or earnings before interest and taxes, NOPAT, which is net operating profit after tax and ROIC, if a firm uses debt or financial leverage, then the  business risk is concentrated on the common stockholders. To illustrate, let's  suppose 10 people decide to form a corporation to manufacture flash memory  drives. There is a certain amount of business risk in the operation if the firm is  capitalized only with common equity, and if each person buys 10% of the stock,  then each investor shares equally in the business risk, because they remember,  each person buys 10% so they are equally weighted in the amount of stock they own. However, suppose the firm is capitalized with 50% debt and 50% equity,  with five of the investors putting up their money in purchasing debt and the other five putting up their money by purchasing the equity. In this case, the five debt  holders are paid before the five stockholders, so virtually all of the business risk  is born by the stockholders. Thus, the use of debt or financial leverage  concentrates business risk on the stockholders. Now we've added more debt  onto our balance sheet. Now the debt holders don't have to assume the risk of  the debt. The only thing that they have to assume that that's the risk on the debt  is not being repaid, but the financial constraint that it puts on the company, it  doesn't affect those debt holders. It affects the shareholders, because now they  have extra debt leverage, pressure to worry about repaying. To illustrate the  impact of financial risk, we can extend the Strasburg electronics. Example,  Strasbourg initially decided to use the technology of plan U, which we'll see in.  Plan U is in the middle right. Plan U is in the third column. We'll see Plan A, U,  and L. So initially decided to use a technology of plan u, which is unlevered  finance with all equity, no debt on levered but now it's considering financing the  technology with 150 million of equity and 50 million in debt at an 8% interest rate shown in plan L. Notice that plan L denotes leverage. Plan U unlevered, right?  So now we have, we're assuming that we take on book equity at 150 million,  and now our debt at 50 million under Plan L. Compare plans U and L. Notice  that the ROIC of 15% is the same for the two plans because the financing  choice doesn't affect operations. Plan L has lower net income 27.6 million  versus 30 million because it must pay interest, but it has a higher return on  equity 18.4% then does plan you? So plan you, its return on equity is 15%  whereas plan L has a return on equity of 18.4% the reason why we have a  higher return on our equities because we have less equity. So the return doesn't  have to be distributed over such a broad scope. We can have a more  concentrated equity base or less equity, therefore deriving a higher return on the equity. So let's look at sales and profit. So net income is lower, right? Our net 

profit is lower under Plan L, but we are using our equity much more efficiently,  driving a higher return than we did at the $30 million net income level, when the  quantity sold is 76 million. Both plans have an ROIC of 4.8% the after tax cost of debt is also 8% which is no coincidence, as ROIC increases above 4.8% the  ROE increases for each plan. But. More of plan l than for plan U. However, if  ROIC falls below 4.8% then the return on equity falls further for plan l then does  for plan U. Thus financial leverage magnifies the return on equity for good or ill,  depending on the ROIC, and is increased and increases the risk of a leveraged  firm relative to the unlevered firm. So adding more risk through leverage or debt  will create negative opportunities.