a. One of the causes of the recent financial crisis in the United States has been excessive risk taking due to underestimation of risk. How does this relate to financial leverage? Can overestimation of risk also be detrimental?
b. Your friend Ricky took a finance class and learned about the risk/return tradeoff. Wanting a high return, Ricky invested in a risky start-up technology company. A year later the company went bankrupt and Ricky lost his entire investment. Ricky is furious with his finance professor for misleading him, claiming he was taught that higher return goes with higher risk. Explain how Ricky misinterpreted the risk/return tradeoff.
Financial Risk Misinterpretation
Financial leverage is truly a barometer of the financial risk of company. However, this is not correct to assume that every company having high financial leverage will provide a high return. There are various factors that need to consider in order to get a high return on a risky start-up.
Answer and Explanation:
a) The statement discussed in regards to the US financial crisis in regards to risk underestimation is correct. The SEC liberalized certain rules in 2004. One of the rules in which relaxation was granted was the net capital rule. This rule had allowed US companies to take more debt and pay fixed interest charges to service these skyrocketing debts. This has led to increased financial fixed costs in the form of interest charges. The companies can?t discharge this liability and the result was the bankruptcy of corporates, individuals, and retrenchment of employees. It has also limited the purchasing power of people. People had no money to buy products and the revenue of companies started reducing as their sales reduced due to the limitation of the purchasing power of people. This has generated a cycle of such a crisis. Employees were losing jobs and the purchasing power, companies were losing revenue due to low sales and top of that their financial obligation in the form of interest was high at that time.
Hence, the underestimation of financial risk was responsible for it.
Can overestimation of risk also be detrimental?
If companies overestimate the financial risk, this would limit their capacity to invest the optimum amount. This would result in underutilization of resources, the same problem occurs in the case of underestimation of financial risk.
Conclusion: Correct estimation of risk is vital to the success of corporates and the economy as well.
b) The high return comes with high risk is a true statement. The risk may be two types of financial risk and operating risk. Financial risk denotes the risk of not servicing fixed financial cost while operating risk denotes the risk of not servicing fixed operating costs.
High financial risk is a situation when a high amount of debt is taken by a company to finance its projects. This will give a higher return if the revenue-generating capacity of the company is more than the cost of debt capital.
However, Return would be low if the company can't generate sufficient revenue to meet the cost of debt capital.
As the money was spent in startup Technology Company by Ricky, the operating fixed cost would be high compared to the revenue which was not considered by Ricky at the time of investment. He only considered a financial risk.
His interpretation of financial risk was not correct, as high financial risk gives a high return if the rate of return on overall capital is higher than the rate of return on debt capital. Being a startup company, the products would not be well absorbed in the market due to not meeting specification requirements or inefficient marketing strategy.
Hence, the fury of Ricky is not valid. He has misinterpreted his professor.
Learn more about this topic:
from Finance 305: Risk ManagementChapter 1 / Lesson 4