A test of the equivalent-risk class hypothesis and a multivariate analysis of firms' business risk discriminatory characteristics

The purpose of this paper was twofold: 1) to retest the assumptions of the equivalent-risk class hypothesis, and 2) to identify a set of business risk discriminatory characteristics. The equivalent-risk class hypothesis assumes firms grouped according to industry classifications are both intragroup business risk homogeneous and intergroup business risk heterogeneous. The findings and implications of many significant research studies in the basic areas of corporate finance and investment theory are contingent on the validity of these two assumptions. Previous attempts to test the assumptions of the equivalent-risk class hypothesis have had conflicting conclusions. Further, the methodologies and business risk measures employed by these test efforts have been challenged. Hence, the lack of consistency in the results of these previous test attempts and the general acceptance in the literature of the assumptions of the equivalentrisk class hypothesis provided justification for a retest of the equivalent-risk class hypothesis' assumptions. Before testing these assumptions, careful attention was given to both the development of a theoretically sound business risk measure and the appropriateness of the testing methodology. Neither assumption of the equivalent-risk class hypothesis was substantiated by the research findings. These findings strongly suggest industry classifications of firms are poor business risk discriminators for financial acamedicians and practitioners. If the assumptions of the equivalent-risk class hypothesis are invalid, researchers must find new methods for business risk discrimination among firms. One such method was presented in this paper. Thirty-five financial and operating variables (characteristics) were calculated for firms in two distinctly different business risk groups. A stepwise multiple discriminant analysis (MDA) program was applied to this data. The results of the MDA revealed discriminant functions containing only a small number of size and dividend policy related variables could correctly classify approximately 90% of the firms in the study into their respective business risk classes. Further, in the presence of size and dividend policy related variables, variables associated with long and short term capital turnover, profitability, and financial leverage were poor business risk discriminators among firms. Finally, the lower business risk firms were characterized by larger size (total assets) and more stable dividend policies with higher dividend payouts than the high business risk firms. The results of the MDA should be encouraging to the financial community, for they imply firms can be categorized into their respective business risk classes by observing a small set of financial characteristics. Further research is needed in this area to develop the implications of these research findings into a more universal working model.