Explain what is meant by business and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain.
Business Risk & Financial Risk
Business and financial risk are two essential components of the total risk a firm has. The financial risk affects the business risk which is ultimately borne by the shareholders of the firm.
Answer and Explanation:
The business risk is a kind of risk that arises from sales risk and other market and economic factors. It is measured by the variability of earnings before interest and taxes (EBIT). Because a firm's business expenditures are fixed, sales risk affects largely the business risk.
In contrast, financial risk arises from using debt financing. When a firm employs debt capital, it has to satisfy credit-holders obligations by incurring interest expenses. The financial risk increases as the firm employ more and more debt.
If Firm A has a greater business risk than that of Firm B, it means that Firm A has a higher cost of equity capital than Firm B. Because the higher business risk increases the cost of equity, the business risk is borne by the stockholders. Besides, the higher the financial risk of a firm, the higher the business risk, and therefore, the higher the cost of equity capital.
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from Finance 305: Risk ManagementChapter 1 / Lesson 4