Saturday, August 13, 2011

Risky Business

One of the basic concepts of capitalism is that of risk.  Investors must decide if they are willing to possibly lose their money in return for possibly making money.  Increasing risk means that the potential profits are increased, but the probability of losing everything increases as well.  The financial services industry makes billions every year performing risk management for their clients, and when performed correctly, this is a boon for society.  This is one of capitalism's many virtues.

In a corporate setting, one of the many risk factors that must be weighed is leverage.  Leverage is simply the amount of money a corporation borrows to conduct their ongoing operations.  By borrowing money, a corporation is inherently increasing the risk for investors.  Here's why:

Suppose you are an investor with $100,000.  You have determined that you are going to use this money to begin a business called "Acme Industries."  When this company begins operations, it has $100,000 to work with.  This money is used to create metal anvils.  After one year, the company makes a profit of $20,000.  $20,000/$100,000=20%, a tidy return.  What would have happened if the business did not do so well, though?  Suppose that the business loses $20,000.  -$20,000/$100,000=-20%, an unfortunate, but not catastrophic, loss.  A mathematical analysis of these possible outcomes is how we measure risk.

Let's re-examine the same scenario, but now we are going to introduce leverage.  Instead of simply using your $100,000 to start a business, you are now going to ask a bank loan for a loan.  The bank lends you $90,000 so that you can start your business. You still invest $10,000 of your own money.  $10,000 equity +$90,000 =$100,000.  You happily march off to start Acme Industries.

What happens under our two scenarios now?  Under our profitable scenario, the business earned a $20,000 profit.  However, you now have only invested $10,000 to earn this money.  $20,000/$10,000=200% return.  This is awesome!  But what about the negative scenario?  The loss of $20,000 is now catastrophic.  Because you only invested $10,000 to begin with, this money is now gone.  Moreover, you now owe the bank $90,000, but the business only has $80,000 left to repay them!  The bank will likely call the loan to recoup what money they can before you lose even more.  The business closes, your employees are laid off, but at least you have your $90,000 that you never invested!

This example is similar to many that you might find in a basic finance textbook.  However, there is a problem with the basic reward structure implied by this capitalist model.  Note that the investor/owner is able to completely dictate the level of risk to meet his/her investment goals.  However, the downside risk of his/her decisions is shared with his employees.  The effects of leverage have definite ramifications on the future cash flows of the employees as they may lose their jobs if the business fails, yet they are not inherently rewarded for any increase in risk.  This point will undoubtedly not be accepted by traditional capitalists, but it is an argument I am willing to have.  While wages have remained stagnant for decades, investor wealth has soared.  Leverage has played a large part in these wealth gains, and because there is an element of risk sharing, there should be an element of reward sharing as well. 

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