The concept of Business Risk
A business risk may be defined as the possible loss due to some unforeseeable, unpredictable and unfavorable event in future. Business risk is defined as the riskiness on the firm’s stock provided that the firm has used no debt capital. It is the risk inherent in the operation of the business. It generally includes the entire spectrum of risks which a company encounters. It is influenced by numerous factors, including sales volume, per-unit price, input costs, competition, the overall economic climate and government regulations. A firm’s business risk arises because of uncertainty associated with the projection of return on invested capital (ROIC). ROIC calculates as below.
ROIC = NOPAT/Capital
In this equation, NOPAT is the net operating profit after tax, which is calculated as net income available to common stockholders plus after-tax interest payment. Capital includes both debt and equity. We assume for simplicity that the firm has used no preferred stock capital. If a company uses no debt capital, its interest expenses will be zero and the capital consists only common equity. Therefore, return on invested capital with zero debt is calculated as below.
ROIC = Net income/Common equity
This equation gives the same result as to that of return on equity (ROE), if the company has used debt capital, In such a case, the business risk is simply indicated by standard deviation, which measures the variability associated to firm’s ROE assuming no debt financing used.