Business and Financial Risk
By definition, risk is the
in the future cash flows.
When discussing sources
of risk, we think of things that cause volatility in cash flow (or earnings, NI, EBIT, ROE,
or other similar measures).
is the variability in cash flows to the firm (and variability in shareholder
ROE) that is due macro-economic factors, industry characteristics, and fixed operating
Sales price variability
Input cost variability
Exposure to macro-economic factors
Example: Two firms, each face 2 possible sales levels.
One firm has low operating
leverage (LOL) and the other has high operating leverage (HOL).
(6,600 – 5,000)/5,000
= (6,800 – 5,000)/5,000
HOL has a higher degree of operating leverage.
For a single percentage change in Sales
Revenue from the current level of 10,000, there will be a 1.8 percent change in EBIT.
Operating Leverage (part of Business Risk)
Fin 336, Leverage, p. 1