Risk and Risk Balancing: What are the Risks and How Can I Manage Them? - PowerPoint PPT Presentation

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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? Types of Risk Business/operations Price, yield ROA Financial Debt load and cost ROE ... – PowerPoint PPT presentation

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


1
Risk and Risk Balancing What are the Risks and
How Can I Manage Them?
2
Types of Risk
  • Business/operations
  • Price, yield ROA
  • Financial
  • Debt load and cost ROE

3
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.

4
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
5
Increasing Risk
6
Risk Balancing Concept
  • Total Risk business/operating risk x financial
    risk

To safely borrow more money you need to manage
business/operating risk.
7
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?

8
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

9
Strategic Business Planning for Commercial
Producers
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