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

5. 40% 30% ROE 1 +12% 20% 10% 0.50 0.66 0% -10% ROE 3 Reduce Operating Risk Return on Assets -20% -30% ROE 2 -48% -40% -50% -60% -70% Increasing Risk

6. Business/Operating Risk Financial Risk 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