CONCEPTS OF BUSINESS AND FINANCIAL RISK

BUSINESS RISK THE RISK INHERENT IN THE FIRM, INDEPENDENT OF THE WAY THE FIRM IS FINANCED. GENERALLY REFLECTED IN THE VARIABILITY OF NET OPERATING INCOME OR NET CASH FLOWS

SOURCES OF BUSINESS RISK MARKET PRICES INPUT PRICES YIELDS BR = σ 1 / cx WHERE, σ 1 IS THE STANDARD DEVIATION OF NET CASH FLOWS WITHOUT DEBT FINANCING, AND CX IS THE EXPECTED NET CASH FLOWS WITHOUT DEBT FINANCING.

FINANCIAL RISK THE ADDED VARIABILITY OF THE NET CASH FLOWS OF THE OWNERS OF EQUITY THAT RESULT FROM THE FIXED FINANCIAL OBLIGATION ASSOCIATED WITH DEBT FINANCING.

FINANCIAL RISK FR = (σ 2 / cx - I) – (σ 1 / cx) FR = TR – BR WHERE, σ 1 IS THE STANDARD DEVIATION OF THE NET CASH FLOWS WITHOUT DEBT FINANCING, σ 2 IS THE STANDARD DEVIATION OF THE NET CASH FLOWS WITH DEBT FINANCING BUT BEFORE DEDUCTION OF DEBT SERVICING PAYMENTS, CX IS THE EXPECTED NET CASH FLOWS WITHOUT DEBT FINANCING, AND I IS FIXED DEBT SERVICING OBLIGATIONS.

FOR SIMPLICITY, THE ASSUMPTION IS MADE THAT (σ 1 = σ 2 ) FINANCIAL RISK MAY BE RESTATED AS: FR = (σ 1 / cx) * (I / CX-I)

THIS STATEMENT FOR FINANCIAL RISK INDICATES THAT FINANCIAL RISK IS DETERMINED BY THE DEGREE OF BUSINESS RISK INHERENT IN THE FIRM (σ 1 / cx) AND THE RELATION (I / CX-I) WHICH IS DETERMINED BY THE FINANCING DECISION.

TOTAL RISK TR = (σ 1 / cx - I) OR TR = (σ 1 / cx) * (CX / CX-I) A TOTAL RISK CONSTRAINT CAN BE STATED AS: TR = (σ 1 / cx) * (CX / CX-I) ≤ β

RISK BALANCING A CHANGE IN BUSINESS RISK FROM SOME EXTERNAL SOURCE, SUCH AS A CHANGE IN PRICE SUPPORT POLICY, COULD CHANGE THE LEVEL OF TOTAL RISK IF ALL OTHER VARIABLES REMAIN UNCHANGED. FOR INSTANCE, IF PRICE SUPPORT PROGRAMS CHANGED WHEREBY THE LEVEL OF BUSINESS RISK INCREASED, THE LEVEL OF TOTAL RISK WOULD INCREASE.

IF THE LEVEL OF TOTAL RISK EXCEEDED THE CONSTRAINT LEVEL, ADJUSTMENT IN FINANCIAL RISK WOULD BE NECESSARY TO MAINTAIN TOTAL RISK AT THE CONSTRAINED LEVEL.