Dow Chemicals
Question 1
How much business risk does AHP face? How much financial risk would AHP face at each of the proposed levels of debt shown in case Exhibit 3? Answer these questions by computing and evaluating the asset beta and the equity beta.
To start with, we have to state the difference between business risk and financial risk.
Business risk represents the risk of the firm’s assets when no debt is used. It is then the risk that is inherent to the firm’s operations. This risk is represented by the asset beta, β(a).
Financial risk takes into account the firm’s leverage. The leverage will have an effect on the stakeholder’s risk. If leverage is too high, amongst other things, the risk of bankruptcy increases: the risk to stakeholders not earning their share increases. The financial risk is incorporated together with the business risk in the equity beta, β(e).
We see that the company has very little debt today, so the tax shield effect of the debt would make an incremental change, the current value of the company is therefore approximately equal to the unlevered value of the company. We therefore decided to continue like the firm is unlevered today, and then we set the current value equal to the unlevered value, VU.
When we look at the different debt levels and compare them with the table provided by S&P, we see that the debt levels suggest one rating and the coverage ratio another.
S&P Medians (79-81)
AAA
AA
A
BBB
BB
B
Debt Ratio
17%
24%
30%
39%
48%
59%
Coverage=EBIT/Interest
18,25
8,57
6,56
3,82
3,27
1,76
Prob.(Bankruptcy)
0,16%
0,72%
1,32%
4,78%
15,68%
36,65% For the 30% debt level for instance the table above suggest a rating of A. The case description however tells us that even at this debt level the company has a very high coverage ratio of 17,5. This would suggest a higher rating. Considering AHP debt avoidance track record and the comparable firm rating, we made the decision to rank the debt levels according to
How much business risk does AHP face? How much financial risk would AHP face at each of the proposed levels of debt shown in case Exhibit 3? Answer these questions by computing and evaluating the asset beta and the equity beta.
To start with, we have to state the difference between business risk and financial risk.
Business risk represents the risk of the firm’s assets when no debt is used. It is then the risk that is inherent to the firm’s operations. This risk is represented by the asset beta, β(a).
Financial risk takes into account the firm’s leverage. The leverage will have an effect on the stakeholder’s risk. If leverage is too high, amongst other things, the risk of bankruptcy increases: the risk to stakeholders not earning their share increases. The financial risk is incorporated together with the business risk in the equity beta, β(e).
We see that the company has very little debt today, so the tax shield effect of the debt would make an incremental change, the current value of the company is therefore approximately equal to the unlevered value of the company. We therefore decided to continue like the firm is unlevered today, and then we set the current value equal to the unlevered value, VU.
When we look at the different debt levels and compare them with the table provided by S&P, we see that the debt levels suggest one rating and the coverage ratio another.
S&P Medians (79-81)
AAA
AA
A
BBB
BB
B
Debt Ratio
17%
24%
30%
39%
48%
59%
Coverage=EBIT/Interest
18,25
8,57
6,56
3,82
3,27
1,76
Prob.(Bankruptcy)
0,16%
0,72%
1,32%
4,78%
15,68%
36,65% For the 30% debt level for instance the table above suggest a rating of A. The case description however tells us that even at this debt level the company has a very high coverage ratio of 17,5. This would suggest a higher rating. Considering AHP debt avoidance track record and the comparable firm rating, we made the decision to rank the debt levels according to