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The cost of capital
The impact of risk
The total return demanded by an investor is dependent on two specific
factors:
the prevailing risk-free rate (R f) of return
the reward investors demand for the risk they take in advancing
funds to the firm
The risk-free rate (R f)is the minimum rate required by all investors for an
investment whose returns are certain.
It is given in questions as the return on treasury bills or government
gilts.
6.1 Return on risky investments – loan notes
Loan notes are riskier than government gilts.
They are less risky than equity investment because:
interest is a legal commitment
interest will be paid before any dividends
loans are often secured
Returns on loan notes will be higher than R f but lower than on equities
6.2 Return on risky investments – equities
The return required by equity investors can be shown as:
Required return = Risk-free return + risk premium
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