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A Test of the Equivalent-Risk Class Hypothesis

Published online by Cambridge University Press:  19 October 2009

Nicholas J. Gonedes
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Extract

Many students of business finance subsume the risks associated with a firm's income stream under two general cognomens, namely, “business risk” and “financial risk.”1 The degree of business risk associated with a firm's income stream is considered to be a function of all determinants of risk except those that relate to the means by which a firm's operations are financed (i.e., the nature of a firm's capital structure). In general, business risk is determined by a firm's asset structure, the purposes for which a firm's assets are used, and the efficiency and effectiveness with which a firm's assets are utilized. The determinants of business risk include the competitive position of a firm, the nature of a firm's operating expenses, the intensity of demand for a firm's products, and a firm's managerial resources, inter alia. A measurement of the variability of net operating income (i.e., earnings before interest expenses and income taxes) is usually employed as a surrogate of business risk.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 4 , Issue 2 , June 1969 , pp. 159 - 177
Copyright
Copyright © School of Business Administration, University of Washington 1969

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References

1 See, for example, Solomon, Ezra, The Theory of Financial Management (Columbia University Press, 1963), pp. 70–71Google Scholar; Porterfield, J. T. S., Investment Decisions and Capital Costs (Prentice-Hall, Inc., 1965), p. 124Google Scholar; Robichek, A. and Myers, S. C., Optimal Financing Decisions (Prentice-Hall, Inc., 1965), pp. 17–18Google Scholar; and Van Home, James C., Financial Management and Policy (Prentice-Hall, Inc., 1968), p. 18.Google Scholar

2 Modigliani, Franco and Miller, Merton, “The Cost of Capital, Corporation Finance, and the Theory of Investments,” American Economic Review (June 1958), pp. 251–296Google Scholar; “Some Estimates of the Cost of Capital to the Electric Utility Industry, 1954–1957,” American Economic Review (June 1966), pp. 333–391.

3 Barges, Alexander, The Effect of Capital Structure on the Cost of Capital (Prentice-Hall, Inc., 1963)Google Scholar.

4 Weston, J. Fred, “A Test of Cost of Capital Propositions,” The Southern Economic Journal (October 1963), pp. 105–112Google Scholar.

5 Brigham, E. F. and Gordon, M. J., “Leverage, Dividend Policy, and the Cost of Capital,” Journal of Finance (March 1968), pp. 85–104Google Scholar.

6 Wippern, Ronald F., “ A Note on the Equivalent Risk Class Assumption,” The Engineering Economist (Spring 1966), pp. 13–22Google Scholar; reprinted in: Weston, J. Fred and Woods, D. H., Theory of Business Finance: Advanced Readings (Wadsworth Publishing Co., 1967), pp. 277–283Google Scholar. References are to the latter source.

7 Ibid., p. 279.

8 Scheffe, Henry, The Analysis of Variance (John Wiley and Sons, Inc., 1959), pp. 55–;83Google Scholar. Wippern states that Scheffe's multiple comparisons test is “substantially unaffected if the normality and equal variance assumptions [of conventional analysis of variance tests] are not satisfied.” Wippern, op. cit., p. 280. Apparently, Wippern is suggesting that Scheffe's test is more “ robust” than the conventional analysis of variance test. Yet, it should be noted that the “robustness” of a statistical test is a complex function of a multiplicity of variables (e.g., shapes and variances of population distributions, sample sizes, location of rejection region, inter alia) In this regard, the reader is referred to: Bradley, J. V., Distribution-Free Statistical Tests (Prentice-Hall, Inc., 1968), chapter 2.Google Scholar

9 Wippern, op. cit., p. 281.

10 Wippern, op. cit., p. 281.

11 General discussions on nonparametric tests may be found in: Siegel, Sidney, Nonparametric Statistics for the Behavioral Sciences (McGraw-Hill, Inc., 1956)Google Scholar, chapter 1; see, also, Fraser, Donald A. S., Nonparametric Methods in Statistics (John Wiley & Sons, Inc., 1957)Google Scholar, chapter 3, and Bradley, op., cit., chapters 1 and 2.

12 Siegel, op. cit., pp. 184–185; see, also, Walsh, John E., Handbook of Nonparametria Statistics, volume II (D. Van Nostrand Co., 1965), p. 324Google Scholar; and Bradley, op. ait., chapter 5.

13 Tables for the KW test appear in: Siegel, op. cit., p. 282, and Walsh, op. cit., p. 325.

14 A set of COMPUSTAT tapes was used as the source of raw data for the statistical tests presented in this paper. The samples of firms and the industry designations were selected from the industrial groupings used in the compilation of data for the COMPUSTAT tapes by Standard Statistics Company. According to the COMPUSTAT manual, each company is assigned to the industry designation which best conforms to its major area of business; see: Standard Statistics Co., COMPUSTAT Information Manual (New York, 1967).Google Scholar