Question

How diversifiable risk affect opportunity cost of capital associated with a particular
firm or investment? I found the relationship between systematic risk and cost of capital in the textbook, but no explain the influence of diversifiable risk on opportunity cost of capital.

Answer 1

Diverisifiable risks are risks that emanate from known and controllable factors, which are unique and are relater to a particular security or industry. These risks can be elimjnated by diversification of portfolio.

• Business risk: It is tge volatility in revenues and profits of a particularvcompanyvdue to iys market conditions, product mix, competition. It may arise due to external reasons or government policies specifically to particular kind of industry or internal reasons like labour efficiency and management.
• Financial risk: These are risk that are associated with the Capital Structure of a company. A company with no debt financing, has no financial risk. Higher financoal leverage higher the financial risk.
• Default risk: These arise due to default in meeting the financi obligations on time. Non payment of financial dues in time.

Cost of Capital has 2 ways of fianancing one is througb debt financing and other equity fianancing. The main thing is the systematic risk or the market risk is responsible for the change in cost of capital. As the market risk affects the equity financing which leads to affect cost of capital. Hence diversifiable risk affects cost of capital only to the extent of equity financing.