Explain how relative risk (from the investor's perspective) impacts the cost of capital for...

Question:

Explain how relative risk (from the investor's perspective) impacts the cost of capital for Genesis Energy.

Cost Of Capital:

The cost of capital is the cost of financing at a firm by the use of internal and external sources of money. The cost of capital will directly affect the capital budgeting decision.

Answer and Explanation:

The cost of capital in a firm will be affected by the cost of debt and the required rate of return on equity. Any changes in those two types of resources will have a direct influence on the cost of capital. From the investor perspective, there are some considerations regarding the possible risks:

Debt: The bond investors would care about the ability to repay the interest payment and principal on the issued debt. That means the liquidity risk will be placed an important role in the investor's decision. A high risk of liquidity will make the bond investors expect to pay for a high coupon-rate bond to offset the potential loss on their payments, in which the cost of debt will increase as well. Consequently, the cost of capital will be affected.

Equity: The equity investors would expect the business to gain additional value on new projects, which will maximize the shareholder wealth. However, if the market interest risk increases, the investors will expect the required rate of return on the equity to increase accordingly, which will make the firm's equity more attractive to the investors. Otherwise, the investors will pick alternatives with the same rate of return. Thus, the interest rate risk will make the cost of equity increase and it will indirectly affect the cost of capital in a firm.


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Required Return vs. Cost of Capital

from Finance 101: Principles of Finance

Chapter 14 / Lesson 1
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