Page 41 - 5.2 i. Manac Finance ITC Summarised Notes

COST OF CAPITAL

Debt Disadvantage

• Business or operation risk emanates from the uncertainty attached to the
many factors that influence the ability of a company to generate
earnings.

• When a company is financed by equity only, ke = business risk.

• Business risk is dependent on the nature of the business, the operating
leverage, that is, whether it is capital-intensive (meaning that it has a
high fixed cost and a low variable cost structure) or labour-intensive

(low fixed cost and high vaiable cost), the state of the physical assets,
competition, product substitution, etc.

• Financial risk is the risk that relates to the borrowing of long and short-
term debt. By financing a part of the company’s assets by borrowing
money, a company becomes liable for making – monthly or annual
interest payments; and capital repayments.

• Shareholders required return for equity and debt financed companies

• = Business risk + Financial risk

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