Question

(a) Define Business and Financial risk as it relates to M&M Proposition

(b) How is Business Risk measured in calculating the cost of equity? 

(c) Townsville Crane Hire has no debt. Its cost of capital is 8.9%. Suppose Townsville converts to a debt-equity ratio of 0.5. The interest rate on the debt is 5%. Ignoring taxes, what is Townsville's new cost of equity? What is its new WACC?

(d) Describe the three (3) types of costs faced by corporations in liquidation, give an example of each type of cost.

Answer 1

Answer (a)

Step 1-

Business Risk and financial risk

Financial risk and business risk are two different types of warning signs that investors must investigate when considering making an investment. Financial risk refers to a company's ability to manage its debt and financial leverage, while business risk refers to the company's ability to generate sufficient revenue to cover its operational expenses.

An alternate way of viewing the difference is to look at financial risk as the risk that a company may default on its debt payments and business risk as the risk that the company will be unable to function as a profitable enterprise.

Financial Risk
A company's financial risk is related to the company's use of financial leverage and debt financing, rather than the operational risk of making the company a profitable enterprise.

Financial risk is concerned with a company's ability to generate sufficient cash flow to be able to make interest payments on financing or meet other debt-related obligations. A company with a relatively higher level of debt financing carries a higher level of financial risk since there is a greater possibility of the company not being able to meet its financial obligations and becoming insolvent.

Some of the factors that may affect a company's financial risk are interest rate changes and the overall percentage of its debt financing. Companies with greater amounts of equity financing are in a better position to handle their debt burden. One of the primary financial risk ratios that analysts and investors consider to determine a company's financial soundness is the debt/equity ratio, which measures the relative percentage of debt and equity financing.

Debt/Equity Ratio = Total Liabilities / Shareholders' Equity

Foreign currency exchange rate risk is a part of the overall financial risk for companies that do a substantial amount of business in foreign countries.

Business Risk

Business risk refers to the basic viability of a business—the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. While financial risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent, and office and administrative expenses.

The level of a company's business risk is influenced by factors such as the cost of goods, profit margins, competition, and the overall level of demand for the products or services that it sells.

difference between business risk and financial risk

The following are the major differences between business risk and financial risk:

1.The uncertainty caused due to insufficient profits in the business due to which the firm is not able to pay out expenses in time is known as Business Risk. Financial Risk is the risk originating due to the use of debt funds by the entity.
2. Business Risk can be evaluated by fluctuations in Earning Before Interest and Tax. On the other hand, Financial Risk can be checked with the help of leverage multiplier and Debt to Asset Ratio.
3. Business Risk is linked with the economic environment of business. Conversely, Financial Risk associated with the use of debt financing.
4. Business Risk cannot be reduced while Financial Risk can be avoided if the debt capital is not used at all.
5. Business Risk can be disclosed by the difference in net operating income and net cash flows. In contrast to Financial Risk, which can be disclosed by the difference in the return of equity shareholders.

Conclusion
Risk and Return are closely interrelated as you have heard many times that if you do not bear the risk, you will not get any profit. Business Risk is a comparatively bigger term than Financial Risk; even financial risk is a part of the business risk. Financial Risk can be ignored, but Business Risk cannot be avoided. The former is easily reflected in EBIT while the latter can be shown in EPS of the company.

step 2

Business and financial risk realtes to M&M proposition

M&M Proposition II shows that the firm's cost of equity can be broken down into two components. The firstcomponent,RA, is the required return on the firm's overall assets, and it depends on the nature of the firm'soperating activities. The risk inherent in a firm's operations is called thebusiness riskof the firm's equity.Referring back to Chapter 11, we see that this business risk depends on the systematic risk of the firm's assets.The greater a firm's business risk, the greaterRAwill be, and, all other things being the same, the greater will bethe firm's cost of equity.The second component in the cost of equity, (RA−RD) × (D/E), is determined by the firm's financial structure.For an all­equity firm, this component is zero. As the firm begins to rely on debt financing, the required returnon equity rises. This occurs because the debt financing increases the risks borne by the stockholders. This extrarisk that arises from the use of debt financing is called thefinancial riskof the firm's equity.The total systematic risk of the firm's equity thus has two parts: business risk and financial risk. The first part(the business risk) depends on the firm's assets and operations and is not affected by capital structure. Given thefirm's business risk (and its cost of debt), the second part (the financial risk) is completely determined byfinancial policy. As we have illustrated, the firm's cost of equity rises when it increases its use of financialleverage because the financial risk of the equity increases while the business risk remains the same.

Answer (b)

step 1- cost of Equity

Cost of Equity is the rate of return a company pays out to equity investors. A firm uses cost of equity to assess the relative attractiveness of investments, including both internal projects and external acquisition opportunities. Companies typically use a combination of equity and debt financing, with equity capital being more expensive.

step 2- Calculating cost of equity

CAPM takes into account the riskiness of an investment relative to the market. The model is less exact due to the estimates made in the calculation (because it uses historical information).

CAPM Formula:

E(Ri) = Rf + βi * [E(Rm) – Rf]

Where:

E(Ri) = Expected return on asset i

Rf = Risk-free rate of return

βi = Beta of asset i

E(Rm) = Expected market return

Answer (d)-

step 1- liquidation of a corporation

Liquidation is the final step in the formal process of dissolving a corporation, regardless of how many shareholders it has. It specifically relates to how a corporation distributes assets that remain after clearing outstanding debts. Internal Revenue Service regulations that apply to all corporations, as well as rules in the corporation’s home state, determine how liquidation takes place. Although state rules share similarities, it’s best to contact the secretary of state for the corporation’s home state to get state-specific information on corporate liquidation rules and regulations.

step 2:-The types of costs faced by corporations in liquidation

1.Liquidation Costs

It means the reasonable costs and out of pocket expenses incurred by Lender in obtaining possession of any Collateral, in storage and preparation for sale, lease or other disposition of any Collateral, in the sale, lease, or other disposition of any or all of the Collateral, and/or otherwise incurred in foreclosing on any of the Collateral, including, without limitation, (a) reasonable attorneys fees and legal expenses, (b) transportation and storage costs, (c) advertising costs, (d) sale commissions, (e) sales tax and license fees, (f) costs for improving or repairing any of the Collateral, and (g) costs for preservation and protection of any of the Collateral.

2. Money owed to creditors

When a company goes into liquidation, its assets are sold by the appointed liquidator in order to repay creditors. Unfortunately, unsecured creditors as a group rarely recoup all the money owed to them because they lie at the bottom of the payment ‘hierarchy’ in insolvency.

This often means there are little, if any, funds remaining after other creditor groups have been paid. If you’re a supplier with a retention of title claim, however, you may be able recover the goods you supplied to your insolvent customer.

For example, a company that files for bankruptcy protection and then is given court approval to give it another try may need to borrow money to stay afloat. If the company fails anyway and goes into liquidation, those last-ditch creditors are generally given priority for repayment over other creditors in their class.

3.Shareholder Debt

A shareholder can petition to wind up their company on the grounds that the company is unable to pay its debts, or that it is ‘just and equitable’ that the company is wound up.

75% (by value of shares) of shareholders must agree to the winding-up to pass a ‘special resolution for winding-up’. After they have applied, shareholders must:

Deliver (‘serve’) a copy of the petition to the company
Provide a certificate of service to the court confirming that the petition has been served on the company.
The shareholders do not have any duties during the company liquidation unless they are also directors of the company. In terms of their financial liability for the company’s debts, shareholders may be asked to pay the liquidator for any shares that have not paid in full for the benefit of the company’s creditors.