Question

1. What is the relationship of business risk, financial risk, and stand-alone risk? How to calculate the financial risk for a firm?

2. How can a firm’s financial leverage boost its return to common shareholders (ROE)? Use an example to explain it.

3. Compare cash budget, the statement of cash flow, and capital budgeting.

Answer 1

Answer 1

Business Risk: It refers to the ability of a firm to make enough sales to cover its operating expenses and produce a profit. The operating expenses include expenses other than financial expenses like salaries, rent, office and administrative expenses, etc. Business risk can further be classified into systematic and unsystematic risks

Financial Risk: It refers to the ability of a firm to cover its financial expenses which includes interest payments and other debts. This risk comes with the fact if the firm opts for debt financing thus, increasing the load of debt charges.

Stand-alone Risk: It refers to the risk created by a specific asset, project, or division/department. This risk is associated with a specific and single aspect of the firm. It is measured assuming that the specific asset (or aspect) exists individually.

Relationship of business risk, financial risk, and stand-alone risk:

The relationship between the above three risks are is surfaced due to their inter-relationship. The theory implies that if stand-alone risk exits for a particular aspect which is financed through debt, may severely impact the ability of the business to pay off its debt obligations as well as operating expenses, which means this may lead to financial and business risks as well. An asset of a business is therefore analyzed to assess its stand-alone risk before financing the same through debt. This may end up increasing the burden of financial risk leading to business risk as well.

Calculation of financial risk

Financial ratios are calculated to measure financial risks. Some of them are:

Debt-Equity Ratio= Debt/Equity

Interest Coverage ratio= Earnings before interest and taxes(EBIT)/Interest on long term debts

Answer 2:

If the firm obtains the capital through debt or fixed charge capital, it attains financial leverage. This happens because use of fixed cost capital magnifies the changes (increase) in operating profit, leaving more for the stock-holder. In-other words, it leads to boosting the results to common-shareholders(ROE).

Example:

Case I Case II

Earnings= 200000 Earnings= 300000

Int on debt=5000   Int on debt=5000

Earning before tax=200000-5000 Earnings before tax= 300000-5000

=195000 =295000   

Here, EBIT is 200000 in case 1 leaving shareholder with 195000. In case II EBIT increases to 300000 and the interest charges remains the same leaving the shareholders with greater earnings(295000).

Financial leverage=% change in EPS/% change in EBIT

Answer 3

Cash Budget:

a) Not mandatory for public companies to make it.

b) Does not include depreciation

c) prepared for a short period of time-weekly, fortnightly etc

d) depends on various functional budgets viz purchase budget, sales budget ect

Cash Flow:

a) Mandatory requirement for public companies to make it.

\b) includes depreciation

c) prepared for a longer period of time like yearly

d) Prepared on the basis of opening and closing balance of cash and includes information related to funds from operations, investment, and financing.

Capital Budgeting:

a) assesses the profitability of a project and in view it in terms of investment criterion i.e; determining and estimating the potential for long term investment.

b) requires huge funds and involves high risk

c) it has a long term perspective

d) affects cost structure