Corporate Finance - Business and Financial Risk

To further examine risk in the capital structure, two additional measures of risk found in capital budgeting:

1.Business risk
2.Financial risk

1.Business RiskA company's business risk is the risk of the firm's assets when no debt is used. Business risk is the risk inherent in the company's operations. As a result, there are many factors that can affect business risk: the more volatile these factors, the riskier the company. Some of those factors are as follows:

• Sales risk - Sales risk is affected by demand for the company's product as well as the price per unit of the product.
• Input-cost risk - Input-cost risk is the volatility of the inputs into a company's product as well as the company's ability to change pricing if input costs change.

As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.

2.Financial RiskA company's financial risk, however, takes into account a company's leverage. If a company has a high amount of leverage, the financial risk to stockholders is high - meaning if a company cannot cover its debt and enters bankruptcy, the risk to stockholders not getting satisfied monetarily is high.

Let's use the troubled airline industry as an example. The average leverage for the industry is quite high (for some airlines, over 100%) given the issues the industry has faced over the past few years. Given the high leverage of the industry, there is extreme financial risk that one or more of the airlines will face an imminent bankruptcy.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/business-financial-risk.asp#ixzz1yewzbr6X

Long-term interest rates on course to double

US lurching towards 'debt explosion' with long-term interest rates on course to double

The US economy is lurching towards crisis with long-term interest rates on course to double, crippling the country’s ability to pay its debts and potentially plunging it into another recession, according to a study by the US’s own central bank

By Philip Aldrick, Banking Editor
Published: 5:44AM BST 06 Jul 2009

Comments 270 Comment on this article

Next Tim Geithner, the US Treasury Secretary, has faced searching question about the growing US Budget deficit
Alan Greenspan, the former chairman of the Federal Reserve, is blamed by many for keeping interest rates too low for too long
Wen Jiabao, the Chinese premier, has expressed his concern over the scale of the US deficit
The deficit is just one of the financial headaches confronting US President Obama, pictured here at the G20 Summit
The US budget deficit is expected to reach about 12pc of the country's gross domestic product this year
George Soros, the billionaire investor, has been among those to express concern about the size of the US deficit and those of other economies
Federal Reserve chairman Ben Bernanke, pictured here with Tim Geither, has acknowledged that the mountain of US debt needs to be reined in
Politicians around the world have said that the bigger deficits are a necessary consequence of keeping a global depression at bay
Bank of England Governor Mervyn King, pictured on the right, has given explicit warnings to Alistair Darling, the Chancellor, to cut the deficit
UK Prime Minister Gordon Brown is arguing that more Government spending will prop up the economy and help cut the deficit


In a 2003 paper, Thomas Laubach, the US Federal Reserve’s senior economist, calculated the impact on long-term interest rates of rising fiscal deficits and soaring national debt. Applying his assumptions to the recent spike in the US fiscal deficit and national debt, long-term interests rates will double from their current 3.5pc.

The impact would be devastating by making it punitively expensive to finance national borrowings and leading to what Tim Congdon, founder of Lombard Street Research, called a “debt explosion”. Mr Laubach’s study has implications for the UK, too, as public debt is soaring. A US crisis would have implications for the rest of the world, in any case.

Using historical examples for his paper, New Evidence on the Interest Rate Effects of Budget Deficits and Debt, Mr Laubach came to the conclusion that “a percentage point increase in the projected deficit-to-GDP ratio raises the 10-year bond rate expected to prevail five years into the future by 20 to 40 basis points, a typical estimate is about 25 basis points”.

The US deficit has blown out from 3pc to 13.5pc in the past year but long-term rates are largely unchanged. Assuming Mr Laubach’s “typical estimate”, long-term rates have to climb 2.5 percentage points.

He added: “Similarly, a percentage point increase in the projected debt-to-GDP ratio raises future interest rates by about 4 to 5 basis points.” Economists are predicting a wide range of ratios but Mr Congdon said it was “not unreasonable” to assume debt doubling to 140pc. At that level, Mr Laubach’s calculations would see long-term rates rise by 3.5 percentage points.

The study is damning because Mr Laubach was the Fed’s economist at the time, going on to become its senior economist between 2005 and 2008, when he stepped down. As a result, the doubling in rates is the US central bank’s own prediction.

Mr Congdon said the study illustrated the “horrifying” consequences for leading western economies of bailing out their banks and attempting to stimulate markets by cutting taxes and boosting public spending. He said the markets had failed to digest fully the scale of fiscal largesse and said “current gilt yields [public debt] are extraordinary low given the size of deficits”.

Should the cost of raising or refinancing public debt in the markets double, “the debt could just explode”, he said, adding that it would come to a head in “five to 10 years”.



http://www.telegraph.co.uk/finance/financetopics/financialcrisis/5754447/US-lurching-towards-debt-explosion-with-long-term-interest-rates-on-course-to-double.html

Assessing indebtedness. How much debt is too much?

Leverage

Leverage and debt assessments are perpetually subjective and are discussed continuously by financial and credit analysts. Some debt is usually regarded as a good thing, for it expands the size of the business and hence the return on owner capital/equity. But too much is too much. Where do you draw the line?

Guiding principles include comparative analysis and vulnerability to downturns. Debt must always be paid back, whether business is good or not - so debt stops being okay when it's too large to cover during a downturn or business strategy change.

Here are a couple of supporting metrics:

Debt to equity

This old standard is common used to get a feel for indebtedness, particularly in comparison with the rest of an industry.

D/E = Total long-term debt / Equity

A company with only $300,000 in long-term debt beyond the portion currently due, against $653 million in equity is virtually debt-free. Such a debt to equity ratio well below 1% is healthy, and so it is for most businesses too. But business analysts may wonder if the company could produce a greater return by borrowing and putting more assets in play. Evidently management has decided that it isn't worth it, so hasn't. That's a better decision than borrowing funds to make the wrong investments.

The investor is left to agree or disagree with management's judgment, but debt-free companies - just like debt-free consumers - come out ahead more often.


Interest coverage

Interest coverage is the ratio of earnings to annual interest, a rough indication of how solvent or burdened a company is by debt.

Interest coverage = Earnings / Annual interest

One way to look at whether a business has the right amount of debt is to look at how much of its earnings are consumed to pay interest on it. (Prudent to keep annual interest less than 20% of earnings.)

When looking at interest coverage, a good question to ask is this: What happens to coverage if, say, business (sales) drops 20%, as in a deep recession?

Enterprise Value

Enterprise Value

Enterprise value (EV) is a company’s market capitalization plus net interest-bearing debt.


In other words, it is the amount of cash required to buy the company at its current price and retire all interest-bearing debt less the cash assets of the business.

EV = Market Capitalization + Net interest-bearing Debt

or

EV = Market Capitalization + Borrowings - Cash


Although used for various reasons by stock analysts, the only useful purpose for calculating EV is as a tool to determine the maximum price a company is prepared to pay to acquire another business.


For instance, one company had a policy of limiting the EV it was prepared to pay to an EBIT multiple of 5. So if EBIT was $20 million, EV should be no more than $100 million. If interest-bearing debt happened to be $50 million, then $50 million would be the maximum price it would pay for the equity of the business.


EV = Market Capitalization + Borrowings - Cash
$100m = Market Capitalization + $50m - $0
Market Capitalization = $100 m - $50 m + $0 = $50 m



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Let’s see the ROE on the acquisition cost of $50 million.


Acquisition cost = $50 million. Calculate ROE


EBIT = $20 m
Interest-bearing debt = $50 m
Interest cost of 8 percent on the debt
Corporate tax rate = 30 percent


Interest cost = $50 m x 8 percent = $4 m


Post-tax profit = EBIT x (100 percent – Corporate tax rate) = [($20 m - $4 m) x (70 percent)] = $11.2 m


ROE = ($11.2 m/ $50 m) = 22.4 percent on an equity cost of $50 million.

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If the company to be acquired had no debt and
acqusition cost was $50 million:



Interest-bearing debt = $ 0
Post-tax profit = EBIT x 70 percent = $20 million x 70 percent = $14 million
Return on cost of $100 million would be 14 percent.


The acquired company would then be geared up by borrowing $50 million.
Interest cost = $50 m x 8 percent = $4 m


Post-tax profit = EBIT x (100 percent – Corporate tax rate) = (20m – 4m) x (70 percent) = $11.2 m


ROE = $11.2m / $50m = 22.4 percent return on the net $50 million acquisition cost.

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EBIT multiple and ROE


From the examples above:

EV = EBIT x EBIT multiple
EBIT multiple = EV/EBIT

EBIT multiple of 5 produces a ROE of 22.4 percent.


Determine the EBIT multiple beyond which debt of 8 percent would produce a return (ROE) of less than 8 percent.
Answer: 1 / (8 percent) = 12.5


Therefore,

Paying an EBIT multiple MORE THAN 12.5, produces Return on Equity (ROE) LESS THAN the interest cost of debt of 8 percent.

Paying an EBIT multiple LESS THAN 12.5, produces Return on Equity (ROE) MORE THAN the interest cost of debt of 8 percent.

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Also read:

http://www.horizon.my/2008/12/malaysian-airlines-is-mas-cheaper-than-air-asia/
Malaysian Airlines – Is MAS Cheaper than Air Asia?