Business risk was defi ned as

Business risk was defi ned as representing the risks to the company ’ s operating results. Financial risk is the risk inherent in the company ’ s choice of fi nancing structure. At this juncture it is worth considering the key decisions to be made in determining a fi nancial strategy, and the associated risks. Think about the fl ows of funds through a company 4 . It will use its asset base to generate profi ts, of which some will be paid out to shareholders as dividends, and the rest will be retained for future growth. Although the level of those profi ts will depend partly on its operating effi ciency, the ultimate level of profi t available to shareholders will depend on the interest burden that the company is carrying – which itself depends on the level of debt it takes on. The directors thus have three decisions to make:

1. How large do we want (or need) the asset base to be? 2. How much of the company ’ s fi nance should be as debt (and therefore how much as equity)? 3. How much of the profi t should be paid out in dividend (and therefore how much should be retained for future growth)?

These decisions are closely linked. If the directors see attractive growth opportunities, they may wish to retain the funds rather than pay them out in dividend (the practicalities of this action will be discussed in Chapter 13). If they feel obliged to pay out dividends, then the expansion could be fi nanced by increasing the company ’ s debt levels. Should the directors feel that such an action would be unwise, then perhaps they should not increase the asset base at all. The three decisions above describe a relatively closed system. There is however a fourth decision for the directors to make:

4. Should we issue new equity?

Issuing new equity expands the company ’ s funding. If it has a target debt–equity ratio (something which appears to be rather more common in academic text books than it is in practice) then increasing the equity base also means that it can take on more debt. Putting it very simplistically, these are the only four decisions that need to be taken in fi nancial strategy 5

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