Letters to the Editor / Corrections & Clarifications
To the Editor:
In a letter to the Oct. 1, 2003, , a letter from Lewis Evans and Kevin...
Business & Money
see Robert Rosenberg, "Purchased Power: Risk Without Return?," , Feb. 15, 1996, p. 36.
Utility Business Risk:
The business risks of many utilities are increasing. Restructuring uncertainty, fuel price volatility, 1 the need for extensive capital expenditures for infrastructure improvement, the incurrence of large deferral amounts during a period of capped rates, potential increases in interest rates, 2 the requirement for significant environmental expenditures that raise costs but not output, the threat of terrorist activity, and, in some instances, risky provider-of-last-resort responsibilities all contribute to this heightened risk. The rating agencies, recognizing increased utility risk, have responded with significant bond downratings over the past few years. Standard & Poor's still lists nearly 40 percent of the electric utility industry as having a negative outlook; in sharp contrast, very few electric utilities have a positive outlook.
Business Versus Financial Risk
Financial analysts often dichotomize the risk of a firm into business risk and financial risk. Business risk reflects the operating risk of the firm and, in particular the risk that net operating income will not be as expected. Financial risk reflects the additional risk imparted to the firm by the presence of fixed-payment capital (i.e., debt). A firm can control, to some extent, its overall level of risk by adopting a more conservative capital structure (i.e., using more common equity) if its business risk is increased. Other things being equal, the more debt a company has, the greater financial risk for both common stockholders and debt holders. This is simply because debt represents a fixed cost that must be paid under any circumstance, or else a company may, in the extreme instance, be subject to bankruptcy.
It is nearly universally agreed that investors require a higher rate of return for an investment in the common equity of a company than they do in its debt. This is so for two important reasons. First, if an enterprise fails, debt holders have priority over equity holders as to the remaining assets of the company. Second, for an ongoing business, debt holders must be paid their contractual level of interest before equity holders can receive anything. Because of this basic fact of financial life, companies may reduce their dividend payments to equity holders when under some financial strain. The cessation of payments to debt holders is a much more rare occurrence and will usually result in bankruptcy, unless corrected. In summary, debt is thought to be less risky than equity because debt holders have priority over equity holders as to: (1) distribution of assets in the case of dissolution of the company; and (2) distribution of earnings in the case of everyday operations. 3 Because equity holders "take second," they require a higher return than do debt holders.
In a more formal academic sense, employing the CAPM model, there are two indications why leverage leads to risk. First, beta is derived by dividing the covariance of market returns and the returns on the stock in question by the variance of the market. The covariance in the numerator, in part, reflects the standard deviation of returns of