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306 Corporate Finance BRILLIANT’S

the opportunity for additional returns is BÝdoñQ>‘|Q> H$mo AQ´>op³Q>d ~ZmZo Ho$ {bE A{V[a³V [aQ>Z©
necessary to make the investment attractive. Ho$ {bE Am°ßÀ¶y©{ZQ>r H$s Amdí¶H$Vm hmoVr h¡& [añH$ E{b‘|Q>
The risk element is composed of five aspects nm§M nhbwAm| na ’$moH$ñS> hmoVo h¡ Omo EH$-Xÿgao Ow‹S>o hmoVo
which are closely inter-twined business risk,
h¢ {~OZog [añH$, ’$m¶Z|{e¶b [añH$, nM}qgJ nm°da [añH$,
financial risk, purchasing power risk, money
and rate risk (also called interest rate risk) and ‘Zr VWm (BÝQ>aoñQ> aoQ> [añH$) VWm ‘mH}$Q> (¶m {bp³d{S>Q>r)
market (or liquidity) risk. [añH$&
 Business risk is the variability in return · {~OZog [añH$ AgoQ²>g na [aQ>Z© ‘| do[aE{~{bQ>r
on assets and affected by the company's hmoVr h¡ VWm H$ånZr Ho$ BÝdoñQ>‘|Q> {S>grOÝg go
investment decisions. à^m{dV hmoVr h¡&
 Financial risk refers to the proportion of · ’$m¶Z|{e¶b [añH$ ’$‘© Ûmam ’$m¶ZoÝñS> Bp³dQ>r VWm
debt and equity with which a firm is S>oãQ> Ho$ AZwnmV go gå~pÝYV hmoVr h¡&
financed.
 Purchasing power risk refers to the change · nM}qgJ nm°da [añH$ àmBg bodb M|Oog Ûmam ‘mnr J¶r
in the purchasing power of money ‘Zr H$s nM}qgJ nmda ‘| MoÝOog na {Z^©a H$aVr h¡&
measured by price level changes.
 Money and rate risk refers to the premium · ‘Zr EÊS> aoQ> [añH$ â¶yMa BÝQ>aoñQ> aoQ²>g ‘| d¥{Õ
in yield demanded by suppliers of capital H$s [añH$ H$mo H$da H$aZo Ho$ {bE H¡${nQ>b Ho$ gßbm¶g©
to cover the risk of an increase in future Ûmam ‘m§Jr OmZo dmbr àr{‘¶‘ H$s ¶rëS> go gå~pÝYV
interest rates.
hmoVr h¡&
 Market (or liquidity) risk refers to the · ‘mH}$Q> (¶m {bp³d{S>Q>r) [añH$ ’$ÊS²>g Ho$ gßbm¶g©
ability of a supplier of funds to sell his Ûmam AnZr hmopëS>¨J H$mo VËH$mb hmoëS> H$aZo H$s
holdings quickly. E{~{bQ>r go gå~pÝYV hmoVr h¡&

Components of Cost of Capital H$m°ñQ> Am°’$ H¡${nQ>b Ho$ H$ånmoZoÝQ>
The overall cost of capital of a firm is EH$ ’$‘© H$s AmodaAm°b H$m°ñQ> Am°’$ H¡${nQ>b
comprised of the cost of the various
’$m¶Z|qgJ Ho$ {d{^ÝZ H$ånmoZoÝQ> H$s H$m°ñQ> ‘| gpå‘{bV
components of financing. Techniques for hmoVr h¡& S>oãQ>, {à’$aoÝg eo¶g©, [aQ>oÝS> A{Zª½g VWm
determining the specific cost of each of these
sources, i.e. debt, preference shares, retained Bp³dQ>r eo¶g© BZ‘| go à˶oH$ gmog}g H$s ñno{g{’$H$
earnings and equity shares are presented. H$m°ñQ> kmV H$aZo H$s Q>op³Z³g àñVwV H$s OmVr h¡&
Although, the techniques presented tend to ¶Ú{n, àñVwV Q>op³Z³g H$s àd¥pËV ñno{g{’$H$ VWm gmW
develop precisely calculated values of specific hr gmW doQ>oS> EdaoO H$m°ñQ> H$s d¡ë¶yO kmV H$aZo H$s
as well as weighted average cost, it is important hmoVr h¡, AV: ¶h OmZZm ‘hËdnyU© h¡ {H$ n[aUm{‘V ‘yë¶
to recognize that the resulting values are at best
rough approximations due to the numerous bJ^J dhr h¡ Omo CZHo$ Ûmam Xem©¶r J¶r {d{^ÝZ ‘mݶVmAm|
assumptions and forecasts that underlie them. VWm ’$moaH$m°ñQ> Ûmam ~Vm¶m J¶m h¡&

Cost of Debt H$m°ñQ> Am°’$ S>oãQ>
The cost of capital for debt is the return S>oãQ> H$s H$m°ñQ> Am°’$ H¡${nQ>b dh [aQ>Z© hmoVm h¡ {Ogo
that potential investors require from the firm's ’$‘© H$s S>oãQ> {g³¶y[aQ>rO O¡go {H$ ~m°ÊS²>g Ho$ ê$n ‘|