Riskiness of companies based on the nature of their industry
BHP Billiton and Rio Tinto are players in the Materials industry- a cyclical natured industry, which gets variation in sales by fluctuations in economic cycle. Not only this, but the input prices are also subjected to variability which in turn increases its business risk. Thus, this industry surely has high investment risk.
Transportation is another industry amongst the given, which has a highest risk element than the rest. It is a highly cyclical industry in nature which implies that changes in economic cycle will definitely affect the industry’s revenue. For instance, recession in economy would increase inflation and decrease the purchasing power of consumers. Hence, a considerable percentage of tourism would decline which would affect its revenue along with consumers opting for less expensive substitute to travel in. Moreover, the industry is also characterized for its high fixed cost in the shape of assets, which would deteriorate the margins further in case of low or declining revenues. Thus, transportation industry and in particularly Air-line companies like Qantas Airlines is the riskiest investment amongst all the mentioned companies.
Relationship between business and financial risk
- Qantas Airways: It is shows high financial leverage along with quite high business risk. The analysis of levered and unlevered beta makes it evident that the company is following Net income approach. This specific approach assumes that increase in debt will not cause ROE to rise (Bose, 2006, p. 66).
- Woolworths: It shows high financial leverage with D/E of 1.69 along with unlevered beta of 0.26 and ROE of 28%. This observation signifies that Woolworth is following the Net operating Income approach of capital structure, which asserts that with increase in debt or financial leverage, ROE gets risen too, thus the advantage of financial leverage is offset by the increase in cost of equity (Bose, 2006, p. 69). The same approach has also been adopted by BHP Billiton and Coca Cola Amatil.
- Rio Tinto: The data shows that unlevered beta or business risk for Rio Tinto is high relative to others. Moreover, it also has financial leverage with D/E of 1.72. Thus, high investment riskiness becomes evident by both levered and unlevered beta. It seems that Rio Tinto is following the traditional approach of capital structure which asserts that a company should opt for the best mix of equity and debt financing, which obviously is based upon the industry’s characteristics (Brealey, Myers & Marcus, 2006, p. 380). Hence, with high D/E, the company provides higher ROE to its investors for bearing higher risks.
- Telstra shows very low business risk along with the lowest financial risk as expressed by levered and unlevered beta at 0.17 and 0.5 respectively. Despite the fact the company is heavily leveraged, its beta along with total shareholders’ return is low. Thus, it seems that Telstra is following the notion of employing financial leverage to inflate ROE.
- CSL on the other hand, has quite high business risk which is why it seems to carry the lowest D/E. Despite having low risk, it shows 21.65% of ROE and 22.7% of total shareholders’ return which shows that it is following a conservative capital structure of having low debt due to high fixed cost requirement of its industry operations.
Capital structure decision making in materials industry
The companies in materials industry carry high business risk primarily because of cyclical nature of business which translates into uncertainty of revenue and earnings. These companies are highly affected by their input prices which in turn affects their operational efficiency and profit margins.
However, these companies carry high D/E which helps inflate their ROE. Moreover, another factor that can highlight the importance of high D/E for these companies is their management’s inclination towards saving on taxes. Last but not the least; the materials industry is a labor intensive as well as capital intensive industry, which is why these companies carry high debt financing so as to keep the financing cost low for them; since interest is tax deductible unlike dividends (Shapiro & Balbirer, 2007, p. 415).
Bose, C. (2006). Fundamentals of Financial Management. 2nd ed. New Delhi: Prentice Hall.
Brealey, R., Myers, S. & Marcus, A. (2006). Fundamentals of Corporate Finance. 6th ed. New York: McGraw Hill.
Shapiro, A. & Balbirer, S. (2007). Modern Corporate Finance. 4th ed. Singapore: Pearson.