Page 50 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Unit 3: Managing Investment Risks

would become a burden to the firm. The fixed cost component has to be kept always Notes
in a reasonable size so that it may not affect the profitability of the company.
Single Product: The internal business risk is higher in case of firm producing a
single product. The fall in demand for a single product would be fatal for the firm.
Hence the company has to diversify the products if it has to face the competition and
the business cycle successfully.
External Risk: It is the result of operating conditions imposed on the firm by
circumstances beyond its control. The external environments in which it operates
exert some pressure on the firm. The external factors are:

Social and regulatory factors
Monetary and fiscal policies of the government
Business cycle and general economic environment within which a firm
operates.

Social and regulatory factors: Harsh regulatory climate and legislation against the
environmental degradation may impair the profitability of the industry. Price
control, volume control, import export control and environment control reduce the
profitability of the firm. This risk is more in industries related to public utility
sectors such as telecom, banking and transportation.
Political risk: It arises out of the change in government policy. With a change in the
ruling party, the policy also changes. Political risk arises mainly in the case of
foreign investment. The host government may change its rules and regulations
regarding the foreign investment.

Business cycle: The fluctuations of the business cycle lead to fluctuations in the
earnings of the company. Recession in the economy leads to a drop in the output of
many industries. Steel and white consumer goods industries tend to move in tandem
with the business cycle. During the boom period there would be hectic demand for
steel products ad white consumer goods. But at the same time, they would be hit
much during recession period. This risk factor is external to the corporate bodies
and they may not be able to control it.
Financial Risk: It refers to the variability of the income to the equity capital due to the
debt capital. Financial risk in a company is associated with the capital structure of the
company. Capital structure of the company consists of equity funds and borrowed funds.
The presence of debt and preference capital results in a commitment of paying interest or
prefixed rate of dividend. The residual income alone would be available to the equity
holders. The interest payment affects the payments that are due to the equity investors.
The debt financing increases the variability of the returns to the common stock holders
and affects their expectations regarding the return. The use of debt with the owned funds
to increase the return to the shareholders is known as financial leverage.
Equity Risk: Equity risk is the risk that one’s investments will depreciate because of
stock market dynamics causing one to lose money.
The measure of risk used in the equity markets is typically the standard deviation of
a security’s price over a number of periods. The standard deviation will delineate
the normal fluctuations one can expect in that particular security above and below
the mean, or average. However, since most investors would not consider fluctuations
above the average return as “risk”, some economists prefer other means of measuring
it.

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