Page 12 - PowerPoint Presentation

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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