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. Conceptually, stockholders face a certain amount of risk that is inherent in a firm’s operations—this is its business risk, which is defined as the uncertainty in projections of future EBIT, NOPAT, and ROIC.
•If a firm uses debt (financial leverage), then the business risk is concentrated on the common stockholders. To illustrate, suppose ten 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.
•However, suppose the firm is capitalized with 50% debt and 50% equity, with five of the investors putting up their money by purchasing debt and the other five putting up their money by purchasing equity. In this case, the five debtholders are paid before the five stockholders, so virtually all of the business risk is borne by the stockholders. Thus, the use of debt, or financial leverage, concentrates business risk on stockholders.




•To illustrate the impact of financial risk, we can extend the Strasburg Electronics example. Strasburg initially decided to use the technology of Plan U, which is unlevered (financed with all equity), but now it’s considering financing the technology with $150 million of equity and $50 million of debt at an 8% interest rate, as shown for Plan L (recall that L denotes leverage).
•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 ROE (18.4%) because the net income is shared over a smaller equity base.

•When the quantity sold is 76 million, both plans have an ROIC of 4.8%. The after-tax cost of debt also is 8%(1 – 0.40) = 4.8%, which is no coincidence. As ROIC increases above 4.8%, the ROE increases for each plan, but more for Plan L than for Plan U.
•However, if ROIC falls below 4.8%, then the ROE falls further for Plan L than for Plan U. Thus, financial leverage magnifies the ROE for good or ill, depending on the ROIC, and so increases the risk of a levered firm relative to an unlevered firm.






Modifié le: mardi 14 août 2018, 08:55