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What is the effect of financial (or operational) leverage on beta?
By the term financial leverage, we usually mean how much debt a firm has, or how ‘levered’ it is, in comparison to equity. This means also how much debt does a firm hold in its capital structure?
Higher debt means high-interest payments and high-interest payments mean a lower profit. These high-interest payments and low profit mean higher risks for shareholders.
What is actually the meaning of beta? Beta is a measure of risk a company holds. It lets us know how much riskier a particular firm is in comparison to an index, such as the S&P index. For example, if the beta of a stock is 1.62, it means that if the returns from the market increase or decrease by 1%, the returns on that stock will either increase or decrease by 1.62%, respectively.
Now, when debt is known to be risky, and beta is a measure of riskiness, how will debt impact the Beta of a stock?
The answer is higher levels of debt will lead to a higher risk-taking firm, and thus a higher beta.
How does operating leverage affect business risk?
Operating leverage is the ratio of operating profit changes to changes in revenue. More the increases in revenue more are the operating profits, but decreases in revenue also meant more decrease in profits.
Scenario-1
For example, a firm with low operating leverage might have no assets, it just buys products and sells them at a slightly higher price. It thus has only a little business risk. If revenues fall 10%, the company only does 10% less business and has 10% lower operating profits. As it does not have debt, so it does not have to think about its business failing. The owners will just make 10% less money. This means that, since the beta of the company is 0, it does not have to take a high risk to earn profits, or if it misses the profits it will lose only an equivalent amount of losses.
Scenario-2
Another manufacturing company might have too much debt it had taken to build a plant that produces some goods. Each item it produces costs less, so its profit from each item sold is much greater. But the company needs to sell at least a certain number of items just to meet the costs of running the plant, plus the costs of servicing the debt. If revenues rise 10%, its operating profit may increase by 20% or more. But if revenues fall 10%, its operating profit could turn negative, or anyway fall below the level necessary to service the debt. That could put it into financial distress.
Conclusion
So, high operating leverage by itself increases business risk, and it often means more beta. The beta could change in value, and service more debts. But the reverse of this is also possible. If a new version of the product comes to the market and becomes popular, the second company may adapt to the change to earn higher revenues than company one. However, whatever the circumstance, a higher value of beta means more risks so the beta of the second company will be higher than the first one.
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