Academic journal article International Journal of Business

The Impact of Financial Risk on Business Risk

Academic journal article International Journal of Business

The Impact of Financial Risk on Business Risk

Article excerpt

I. INTRODUCTION

Capital structure refers to the mix of debt and equity that are issued by firms to raise funds for taking projects, and is often measured by the ratio of debt to firm value or the ratio of debt to asset. Thus, the higher the capital structure of a firm, the more debt the firm tends to have. On the other hand, when a firm issues debt to raise funds for taking projects, financial risk such as bankruptcy is introduced. Therefore, the higher the capital structure, the more financial risk the firm tends to bear. While there is a lot of studies about capital structure and its impact on asset prices, it is unclear whether or not capital structure and its associated financial risk can affect business risk or the risk of the projects taken by a firm.

In this paper, we directly study the impact of capital structure on the volatility for future earnings or cash flows. Since the volatility for future earnings or cash flows is directly related to business risk or the risk of the projects taken by a firm, this study will help shed light on the impact of financial risk on business risk. We use two ways to represent capital structure. The first way is to use the ratio of a firm's debt to asset, and the second the ratio of debt to firm value, where firm value is equal debt plus the book value of equity. The use of these two different measurements of capital structure aims to provide a clear picture on the impact of capital structure on the risk of projects taken by a firm.

The motivation of our study for the impact of capital structure on project risk stems from the following three reasons. First, capital structure and the related question of what is the optimal amount of debt a firm should have are extensively studied in corporate finance. On the other hand, capital investment is also an important research topic in corporate finance. Therefore, the examination of the impact of capital structure on future capital investment links the studies in these two areas. Second, while previous research extensively examines capital structure and its impact on asset prices, it don't address the impact of capital structure on future capital investment, i.e., the impact of capital structure on the volatility for future earnings or cash flows. Third, there are no any empirical studies that focus on the impact of capital structure on capital investment or the impact of financial risk on business risk. Thus our study is the first attempt in this direction.

We regress the volatility for future earnings or cash flows on capital structure and other firm characteristic variables such as firm size, firm age and bond credit rating. Regardless of how capital structure is represented, we all find out that capital structure has a significant impact on the volatility for future earnings or cash flows. Specifically, the volatility for future earnings or cash flows increases with capital structure, or future business risk increases with financial risk. This empirical result implies that firms with high capital structure are more likely to take very risky projects so that future earnings or cash flows become more volatile. This empirical result is also interesting since it provides a brand new perspective on the relationship between financial risk and business risk. It is a well-known fact that business risk affects financial risk. More specifically, other things being the same, the firms with a larger business risk such as more volatile future earnings or cash flows tend to have a larger financial risk than the firms with a lower business risk. But on the other hand, in the finance literature related to capital structure, little is known about whether or not financial risk can affect business risk. Therefore, it is in this perspective that our empirical result is very interesting, since it shows that financial risk can also affect business risk.

We also find out that the relationship between capital structure and the volatility for future earnings or cash flows cannot be explained away by other firm characteristic variables such as firm size, firm age, and the S&P credit rating for long-term corporate bonds. …

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