Risk and Risk Balancing: What are the Risks and How Can I Manage Them?

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Risk and Risk Balancing What are the Risks and
How Can I Manage Them?
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Types of Risk

• Business/operations
• Price, yield ROA
• Financial
• Debt load and cost ROE

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Principle of Increasing Risk

• The tendency for total risk to become greater at
  an increasing rate as the relative amount of
  nonequity capital in the business increases.

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Principle of Increasing Risk
nonequity capital / assets nonequity capital / assets nonequity capital / assets
Equity Capital 200,000 200,000 200,000
Nonequity Capital 0 200,000 400,000
Total Capital 200,000 400,000 600,000
Income when ROA is 15
Returns to Capital Used 30,000 60,000 90,000
Cost of nonequity capital (9) 0 18,000 36,000
Total return on equity capital 30,000 42,000 54,000
ROE 15 21 27
Income when ROA is -15
Returns to Capital Used (30,000) (60,000) (90,000)
Cost of nonequity capital (9) 0 18,000 36,000
Total return on equity capital (30,000) (78,000) (126,000)
ROE -15 -39 -63
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Increasing Risk
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Risk Balancing Concept

• Total Risk business/operating risk x financial
  risk

To safely borrow more money you need to manage
business/operating risk.
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Best Capital Structure

• More debt reduces total cost of capital,
  increases return
• More debt increases risk
• How much risk are you willing to take to get more
  return?

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Summary

• Risk increases rapidly as leverage increases, but
  debt is less expensive than equity
• To reduce total risk, must manage operating risk
  when borrowing money

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Strategic Business Planning for Commercial
Producers