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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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