Description
risk associated in financial management
Risk
Uncertainty means not knowing exactly what will happen in the future. Uncertainty is not knowing what s going to happen. Risk is how we characterize how much uncertainty exists: The greater the uncertainty, the greater the risk. Risk is the degree of uncertainty.
Risk
? Financing and Investment include many kinds of risk such as: Cash flow risk Business risk Sales risk Operating risk Financial risk Default risk Reinvestment risk Prepayment risk Call risk Interest rate risk Purchasing power risk Currency risk Portfolio risk Diversifiable risk Nondiversifiable risk
?
? ? ? ?
? Cash flow risk is the risk that the cash flows of an investment will not materialize as expected. For any investment, the risk that cash flows may not be as expected in timing, amount, or both is related to the investment s business risk. ? Business risk is the risk associated with operating cash flows. Operating cash flows are not certain because neither are the revenues nor the expenditures comprising the cash flows.
The risk that comes about from the mix of fixed and variable costs as operating risk. The greater the fixed operating costs relative to variable operating costs, the greater the operating risk.
How operating risk affects cash flow risk?
Let s look at how sensitive a firm s operating cash flows are to changes in demand, as measured by unit sales. This operating cash flow elasticity, is known as the degree of operating leverage (DOL). The degree of operating leverage is the ratio of the percentage change in operating cash flows to the percentage change in units sold.
DOL =
Percentage change in operating cash flows Percentage change in units sold
Suppose the price per unit is $40, the variable cost per unit is $30, and the total fixed costs are $5,000. If we go from selling 1,000 units to selling 1,500 units, an increase of 50% of the units sold, operating cash flows change from: 1,000 Units Sold Sales $40,000 Less variable costs 30,000 Less fixed costs 5000 Operating cash flow 5000 1,500 Units Sold $60,000 45,000 5000 10000
Operating cash flows doubled when units sold increased by 50%. What if the number of units decreases by 25%, from 1,000 to 750?
DOL = Percentage change in EBIT / Percentage change in Quantity DOL = Q(P-V) / [Q(P-V) F] Consider the data for Ayur ltd. P = $150, V = $100 and F= $ 120000. Calculate the DOL for Q=4000 units and Q = 6000 units
DOL = Q(P-V) / [Q(P-V) F]
Ans: = 4000 *(150-100) 4000*(150-100) - 120000 = 2.5 Similarly for Q = 6000 units = 6000*(150-100) 6000*(150-100) 120000 = 1.66
Behavior of DOL The operating Break-even point is expressed as: Q = F / (P V) DOL (Q= 1000) = -0.714 DOL (Q = 2000 ) = -5.000
DOL (Q = 2400 ) = DOL (Q = 3000 ) = 5.000 DOL (Q = 4000 ) = 2.500 DOL (Q = 5000 ) = 1.923 DOL (Q = 10000 ) = 1.136
1. There is a unique DOL for each level of output. 2. DOL is negative below the operating break-even point 3. DOL is undefined at the operating breakeven point 4. DOL is positive beyond the operating break-even point
Application of Operating Leverage
DOL enables us to understand how EBIT would change given a certain change in Q e.g. P=$150, V = $ 100 and F = $ 120000. Let the current level of output is 3000 units. What percentage change would occur in the EBIT if the output increases by 10 percent? DOL(Q=3000 ) * 10 % = 3000*(150-100) 3000(150-100)-120000 = 5 * 10% = 50% 1.
Application of Operating Leverage
1. Measuring Business Risk Business risk refers to the variability of EBIT. The degree of operating leverage captures business risk to some extent since it measures the extent to which EBIT will vary from its forecast value for a given error in the forecast value of Q. The larger the degree of operating leverage, other things being equal, the greater the variability around the forecast value of EBIT.
doc_827257254.pptx
risk associated in financial management
Risk
Uncertainty means not knowing exactly what will happen in the future. Uncertainty is not knowing what s going to happen. Risk is how we characterize how much uncertainty exists: The greater the uncertainty, the greater the risk. Risk is the degree of uncertainty.
Risk
? Financing and Investment include many kinds of risk such as: Cash flow risk Business risk Sales risk Operating risk Financial risk Default risk Reinvestment risk Prepayment risk Call risk Interest rate risk Purchasing power risk Currency risk Portfolio risk Diversifiable risk Nondiversifiable risk
?
? ? ? ?
? Cash flow risk is the risk that the cash flows of an investment will not materialize as expected. For any investment, the risk that cash flows may not be as expected in timing, amount, or both is related to the investment s business risk. ? Business risk is the risk associated with operating cash flows. Operating cash flows are not certain because neither are the revenues nor the expenditures comprising the cash flows.
The risk that comes about from the mix of fixed and variable costs as operating risk. The greater the fixed operating costs relative to variable operating costs, the greater the operating risk.
How operating risk affects cash flow risk?
Let s look at how sensitive a firm s operating cash flows are to changes in demand, as measured by unit sales. This operating cash flow elasticity, is known as the degree of operating leverage (DOL). The degree of operating leverage is the ratio of the percentage change in operating cash flows to the percentage change in units sold.
DOL =
Percentage change in operating cash flows Percentage change in units sold
Suppose the price per unit is $40, the variable cost per unit is $30, and the total fixed costs are $5,000. If we go from selling 1,000 units to selling 1,500 units, an increase of 50% of the units sold, operating cash flows change from: 1,000 Units Sold Sales $40,000 Less variable costs 30,000 Less fixed costs 5000 Operating cash flow 5000 1,500 Units Sold $60,000 45,000 5000 10000
Operating cash flows doubled when units sold increased by 50%. What if the number of units decreases by 25%, from 1,000 to 750?
DOL = Percentage change in EBIT / Percentage change in Quantity DOL = Q(P-V) / [Q(P-V) F] Consider the data for Ayur ltd. P = $150, V = $100 and F= $ 120000. Calculate the DOL for Q=4000 units and Q = 6000 units
DOL = Q(P-V) / [Q(P-V) F]
Ans: = 4000 *(150-100) 4000*(150-100) - 120000 = 2.5 Similarly for Q = 6000 units = 6000*(150-100) 6000*(150-100) 120000 = 1.66
Behavior of DOL The operating Break-even point is expressed as: Q = F / (P V) DOL (Q= 1000) = -0.714 DOL (Q = 2000 ) = -5.000
DOL (Q = 2400 ) = DOL (Q = 3000 ) = 5.000 DOL (Q = 4000 ) = 2.500 DOL (Q = 5000 ) = 1.923 DOL (Q = 10000 ) = 1.136
1. There is a unique DOL for each level of output. 2. DOL is negative below the operating break-even point 3. DOL is undefined at the operating breakeven point 4. DOL is positive beyond the operating break-even point
Application of Operating Leverage
DOL enables us to understand how EBIT would change given a certain change in Q e.g. P=$150, V = $ 100 and F = $ 120000. Let the current level of output is 3000 units. What percentage change would occur in the EBIT if the output increases by 10 percent? DOL(Q=3000 ) * 10 % = 3000*(150-100) 3000(150-100)-120000 = 5 * 10% = 50% 1.
Application of Operating Leverage
1. Measuring Business Risk Business risk refers to the variability of EBIT. The degree of operating leverage captures business risk to some extent since it measures the extent to which EBIT will vary from its forecast value for a given error in the forecast value of Q. The larger the degree of operating leverage, other things being equal, the greater the variability around the forecast value of EBIT.
doc_827257254.pptx