Video Transcript: Business Risk and Operating Leverage

Hello, welcome. We're going to discuss business risk and operating leverage.  Business risk is the risk of a firm's common stockholders, the risk they would  face if the firm had no debt. In other words, it is the risk inherent in the firm's  operations, which arises from uncertainty about future operating profits and  capital requirements. Business risk depends on a number of factors, beginning  with variability in product demand and production cost. If a high percentage of  the firm's costs are fixed and do not decline when demand falls, then the firm  has high operating leverage, which increases its business risk because  payments on debt are fixed and they won't decrease even if operations go  down, then we will have increased business risk because we will have to pay for the leverage yield or the interest payments out on the debt, and that won't  change. That amount won't change, even if our business proceeds or our sales  revenue declines, our debt payments are staying the same, so therefore we  have a greater business risk, a high degree of operating leverage implies that a  relatively small change in sales results in a relatively large change in earnings  before interest in taxes, net profit, net operating profits after taxes, return on  invested capital, return on assets and return on equity. So a high degree of  operating leverage, a high degree of operating leverage tells us that a small  change in sales results in a relatively large chain change in these so if we have  so, if we have a small change in these results, we'll have a large change in  these ratios. Other things held constant. The higher firms fixed costs, the greater its operating leverage. Higher fixed costs are generally associated with highly  automated capital intensive firms and businesses that employ highly skilled  workers who must be retained and paid even when sales are low. Firms with  high product development costs must be maintained to complete ongoing  research and development projects. To illustrate the relative impact of fixed  versus variable cost. Consider Strasburg electronics company, a manufacturer  of components used in cell phones. Strasburg is considering several different  operating technologies and several different financing alternatives. We will  analyze its financing choices, but for now, we'll focus on its operating plans. So  Strasburg is comparing two plans, each requiring a capital investment of 200  million. Assume for now that Strasburg will finance its choice entirely with equity. Each plan is expected to produce 10 million units per year at a sales price of $2  per unit plan, A's technology requires a smaller annual fixed cost than plan U's,  but Plan A has higher variable leverage, and we denote the third plan with L  because it does not have financial leverage. Plan L is discussed in the next  section the projected income statements and selected performance measures  for the first year, notice that plan U's performance measures are superior to plan  A's if the expected sales occur. So we are again going to look at plans A, U, and  L. Plan A will be profitable if unit sales are above 40 million, whereas plan U  requires sales of 60 million units before it's profitable. This difference occurs  because plan U has higher fixed costs, so more units must be sold to cover 

these fixed costs. Panel, a of the figure below illustrates the operating  profitability of these two plans for different levels of unit sales, because these  companies have no debt, the return on assets measures operating profitability,  we report ROA instead of EBIT to facilitate comparisons.