Question Tag: Business risk

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  • 3 Marks

AFM – May 2016 – L3 – Q4a – Hedging against financial risk: Non-derivative techniques, Economic environment for multinational

Outline three risk mitigation strategies that a company can adopt to reduce risks affecting profitability.

a) Booms and Bumps Limited has recently been registered as a multinational company dealing in the production and drilling of crude oil in the Oil and Gas industry. Due to uncertainties surrounding the future prospects of the industry, management has hired you as a financial consultant to conduct a risk assessment about the viability of the firm. In the course of the assessment, you constructed a risk register containing various risks that have the potential to affect negatively the profitability of the company.

Required:
Outline THREE basic strategies the management of the company can adopt to mitigate the impact of the risks. (3 marks)

Risk Mitigation Strategies for an Oil and Gas Company

  1. Hedging
    • The company can hedge its exposure to risks such as fluctuating oil prices or currency exchange rates by entering into financial contracts that fix or stabilize future prices. Hedging against price volatility ensures more predictable revenues and reduces the impact of unfavorable market movements.
      (1 mark)
  2. Diversification
    • The company can diversify its operations by investing in different geographic regions or related industries. By spreading investments across various markets and products, the company reduces its dependency on a single market or resource, thus lowering overall risk.
      (1 mark)
  3. Risk Mitigation through Control
    • Implementing strong internal controls and policies to avoid exposure to high-risk projects or ventures that have a lower rate of return. By conducting thorough risk assessments before investing, the company ensures that only projects that meet certain risk-reward criteria are pursued.
      (1 mark)
  • 10 Marks

FM – May 2020 – L2 – Q1b – Capital structure | Portfolio theory and the capital asset pricing model (CAPM)

Analyze the degree of operating and financial leverage for two subsidiary companies to determine the implications for their capital structure.

Firm A and Firm B are both subsidiary companies of Groupe Trojan Electronics. The directors of Groupe Trojan Electronics are reviewing the capital structure of the two subsidiary companies. You have been engaged to advise the directors on the appropriate capital structure for the subsidiaries.

You have obtained extracts from the financial results of the two companies for the past financial year and projection of the annual results for the current year, which is in its first quarter.

Required:

i) Compute the degree of operating leverage for each of the two companies. Based on the degree of operating leverage you obtain, advise the directors on the relative level of business risk associated with the two subsidiaries and the implication of that for capital structure design. (5 marks)

ii) Compute the degree of financial leverage for each of the two companies. Based on the degree of financial leverage you obtain, advise the directors on the relative level of financial risk associated with the two subsidiaries and the implication of that for capital structure design. (5 marks)

i) The degree of operating leverage (DOL)
The DOL of Firm A is 1.26, and that of Firm B is 1.76:

Implication:
The DOL assesses the volatility in operating profit due to changes in revenue. Firm B, with a higher DOL, presents a higher business risk to Groupe Trojan than Firm A. The implication for the capital structure decision is that Firm A, which has a lower DOL, could sustain higher debt in its capital structure than Firm B.

ii) The degree of financial leverage (DFL)
The DFL of Firm A is 1.3 and Firm B is 2.84:

Implication:
The DFL indicates the level of financial risk. Firm B, with a higher DFL, presents a higher financial risk to Groupe Trojan than Firm A. The implication for the capital structure decision is that Firm A, with a lower DFL, could sustain higher debt in its capital structure than Firm B.

 

  • 20 Marks

FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty

Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.

a) Understanding risk is key for a robust risk and control environment in modern business organisations.
Required:
In the light of the above, explain the following:
i) Systematic risk (2 marks)
ii) Business risk (2 marks)
iii) Financial risk (2 marks)

b) Quantum Investment Ltd in the past has been concentrating all its investments in one project that performed badly consistently over the past few years. They have therefore decided to adopt a diversification strategy by investing in projects A, B, and C. The table below presents the Net Present Value (NPV) of the projects under different states of the economy.

State of Economy Probability Project A Project B Project C
Bad 0.2 GH¢10 million GH¢12 million GH¢15 million
Average/Normal 0.5 GH¢20 million GH¢22 million GH¢30 million
Good 0.3 GH¢35 million GH¢40 million GH¢45 million

The company has GH¢200 million for investments in these three projects:
Project A = GH¢40 million
Project B = GH¢60 million
Project C = GH¢100 million

Required:
Compute the expected NPV for each of the three projects. (9 marks)

c) In capital structure decisions, there are two views of gearing and weighted average cost of capital (WACC): the traditional view and the Modigliani-Miller view.
Required:
Explain the two views with respect to gearing and WACC. (5 marks)

a) Explanation of Risks:

i) Systematic Risk:
Systematic risk is the risk inherent in the economy that affects all businesses. It cannot be diversified away and is often associated with macroeconomic factors such as interest rates, inflation, and economic cycles.

(2 marks)

ii) Business Risk:
Business risk is specific to the industry or the nature of the business a company is engaged in. It relates to the variability in earnings due to the nature of the operations. Some businesses, like technology companies, are inherently riskier than others, such as utilities.

(2 marks)

iii) Financial Risk:
Financial risk arises from the way a company finances its operations, particularly the use of debt. Companies with higher levels of debt (gearing) face higher financial risk, as they are more exposed to the risk of default if their earnings are insufficient to meet debt obligations.

(2 marks)

b) Expected NPV for Each Project:

c) Views on Gearing and WACC:

  • Traditional View:
    The traditional view suggests that there is an optimal level of gearing where the WACC is minimized, and the value of the company is maximized. As gearing increases, the cost of equity rises, but the benefit of cheaper debt outweighs this increase up to a certain point, after which further increases in gearing raise the WACC.
  • Modigliani-Miller View:
    Modigliani and Miller proposed that, under certain assumptions (such as no taxes, no bankruptcy costs, and perfect markets), the WACC remains constant regardless of the level of gearing. They argued that the value of the firm is unaffected by how it is financed, although this theory has been adjusted in real-world applications to account for taxes and bankruptcy costs.(5 marks)

 

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