Business Risk and Operating Leverage

•Business risk is the risk a firm’s common stockholders would face if the firm had no debt.
•In other words, it is the risk inherent in the firm’s operations, which arises from uncertainty about future operating profits and capital requirements. Business risk depends on a number of factors, beginning with variability in product demand and production costs.
•If a high percentage of a firm’s costs are fixed and hence do not decline when demand falls, then the firm has high operating leverage, which increases its business risk.

•A high degree of operating leverage implies that a relatively small change in sales results in a relatively large change in EBIT, net operating profits after taxes (NOPAT), return on invested capital (ROIC), return on assets (ROA), and return on equity (ROE).
•Other things held constant, the higher a firm’s fixed costs, the greater its operating leverage. Higher fixed costs are generally associated with (1) highly automated, capital intensive firms; (2) businesses that employ highly skilled workers who must be retained and paid even when sales are low; and (3) firms with high product development costs that must be maintained to complete ongoing R&D projects.

•To illustrate the relative impact of fixed versus variable costs, consider Strasburg Electronics Company, a manufacturer of components used in cell phones. Strasburg is considering several different operating technologies and several different financing alter- natives. We will analyze its financing choices in the next section, but for now we will focus on its operating plans.
•Strasburg is comparing two plans, each requiring a capital investment of $200 million; assume for now that Strasburg will finance its choice entirely with equity. Each plan is expected to produce 110 million units (Q) per year at a sales price (P) of $2 per unit. Plan A’s technology requires a smaller annual fixed cost (F) than Plan U’s, but Plan A has higher variable costs (V). (We denote the second plan with U because it has no financial leverage, and we denote the third plan with L because it does have financial leverage; Plan L is discussed in the next section.) The projected income statements and selected performance measures for the first year. Notice that Plan U’s performance measures are superior to Plan A’s if the expected sales occur.





•Plan A will be profitable if unit sales are above 40 million, whereas Plan U requires sales of 60 million units before it is profitable. This difference occurs because Plan U has higher fixed costs, so more units must be sold to cover these fixed costs. Panel a of the Figure below illustrates the operating profitability of these two plans for different levels of unit sales. Because these companies have no debt, the return on assets measures operating profitability; we report ROA instead of EBIT to facilitate comparisons. 




Last modified: Tuesday, August 14, 2018, 8:55 AM