CHAPTER 3 RISK & RETURN

Overview
Distinguish between business risk, financial risk and investment risk s Calculate the following indicators of return
s

x Earnings before interest and tax x Percentage return to shareholders x Expected return based on probabilities

Overview - continued
s

Calculate the following indicators of risk

x Degree of operating leverage x Degree of financial leverage x Degree of combined leverage x Variance of returns x Standard deviation of returns x Coefficient of variation x Z score x Correlation & covariance
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Introduction
s This chapter looks at the methods in

which expected return can be measured. s What is the uncertainty that surrounds such expected return i.e, the risk of the returns that may not be achieved and the measure of risk?
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There is a trade-off between risk and return.

Return

Risk
Typically, higher risk, higher return

The concept of risk

s

The word risk is usually used in a context of potential hazard of possibility of an unfortunate outcome resulting from a given action. In financial management, risk indicates the expectation that the actual outcome of the project may differ from the expected outcome. The term risk and uncertainty are used interchangeably

The concept of risk

s

However, there are formal difference between these terms Uncertainty implies either that all alternative possible outcomes cannot be identified (no probability can be attached) Risk implies that it is possible to attach probabilities to the identified expected outcome
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What is Business risk

s

Business risk refers to the nature of the business itself and the uncertainty that surrounds the business operating environment This is reflected in variability of sales and cost structure Variability of sales include
x Increased competition x Availability of substitute products x Effects of recession
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Business risk
s

Variability of costs include

x Relationship between fixed and variable cost

Example:
Leverage Ltd has the following budgeted information 3 Fixed cost (FC) $100 000 3 Variable cost (VC) $4 per unit 3 Selling price (S) $10 per unit 3 Expected demand 30 000 units (minimum)
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Business risk
Breakeven analysis
s

Given: Fixed cost (FC) $100 000 Variable cost (VC) $4 per unit Selling price (S) $10 per unit Expected demand 30 000 units (minimum)

Break even units

What is the break even units?

= fixed costs contribution per unit

= FC S - VC = 100 000 10 4 = 16 667 units

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Business risk
(000) $ 300 Profit Sales revenue

200 Total Cost

100

Break even

100k fixed cost

10

20

30

40

units
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Business risk
s

How to calculate EBIT

Effects on Earnings Before Interest and Tax (EBIT)

Given selling price = $10

30 000 units

40

000 units Sales ($10 unit) 000 Variable costs ($4 unit) 120 000 160 000 Given variable Contribution cost (VC) = $4 180 000 240 000 Fixed costs 100 units, EBIT increased 100 It can be seen that, while sales increased by 33.3% from 30K to 40K000 75% from $80K to $140K. To calculate this leverage effect, we use the degree of operating 000 leverage (DOL) which will be discussed in next slide. EBIT 80 000 140 000 12 ______________________ 300 000 400

Business risk
s

The degree of operating leverage is x DOL = contribution

EBIT

= S VC S VC F = 300 000 120 000 80 000 = 2.25

x This means an increase in sales of 10%

will lead to an increase of, 10% x 2.25, that is 22.5% in EBIT.

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Business risk
s Assume now that Leverage Ltd decides

to install machinery which will increase fixed costs by $50 000 per year and reduce variable costs by $1.50 to $2.50 per unit s The new break-even units will be 20 000 units. [150000/(10.00 2.50)
Given B/E units = FC S - VC
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Business risk
30 000 units 40 000 units ______________________ Sales ($10 unit) 300 000 Variable costs ($2.50 unit) 75 000 Contribution 225 000 Fixed costs 150 000 Fixed cost EBIT 75 000 increased 50K to
150K from 100K

400 000 100 000 300 000 150 000 150 000

The DOL at 30 000 units = 300 000 75 000 Sale VC 75 000 Sale = 3 300K to 400K) results in VC F With DOL = 3, an 33.3% increase in sales (from
an increase of 100% in EBIT ( EBIT increased from 75K to 150K) 3 *33.3% increase in sales =100% increase in EBIT =>
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Business risk
s The riskier option (higher fixed cost)

offers greater potential losses if sales volume is low, but greater potential profits when sales volume is high. s Thus, total business risk is therefore a function both sales and costs

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What is Financial risk

s

Financial risk results from the practice of financing a part of the firms assets with interest bearing debt with a view of increasing the ultimate return to ordinary shareholders. When the firm is experiencing boom sales, the return on assets is likely to be higher than the cost of debt. Thus, positive financial leverage is experienced. The degree of financial leverage is x DFL = EBIT

s s

EBIT - I

Where I is the total interest expense on all debt

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Total company risk

Operating leverage and financial leverage work together to create what is referred to as degree of combined leverage (DCL) s The degree of combined leverage is
s =

S VC S VC F - I

S sales VC - variable cost F- fixed cost I interest expense

Or DCL = Contribution Net income before taxation

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Total company risk

Example:
DCL= S VC S VC F - I Leverhi Gearlo Sales S 810,000 891,000 Less: Variable costs VC 144,000 549,000 Contribution 666,000 342,000 Less: Fixed costs F 333,000 63,000 EBIT 333,000 279,000 Less: Interest I 63,000 9,000 Net Income 270,000 270,000

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Total company risk

Leverhi Gearlow ______________________
DOL

S VC

S VC F

666 000 333 000 = 2.0 333 000 270 000 = 1.23 = 2.46

342 000 279 000 1.23 279 000 270 000 1.03 1.27

DFL

EBIT EBIT - I

Degree of Combined leverage

DCL = DOL x DFL

Or DCL = S VC S VC F I

666 000 270 000 = 2.46

342 000 270 000 1.27

From the above, it shows that Leverhi will be classified as a more risky business operation because of the greater potential loss in times of poor sales (higher fixed cost). However, it has a greater potential for profit (due to its higher DOL) should sales increase.

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Measuring Expected Return and Risk

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