Question

1. Explain what is meant by business risk and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain.

2. Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?

Answer 1

1) Business risk is the risk that the company will not be able to generate enough cashflows to cover the cost of operation. Business risk is related to the environment in which the company operates like tough competition, constant innovation and your operating leverage whereas on the other financial risk is the risk related to not being able to meet the interest expense which is due to debt in the capital structure. Higher debt in the capital structure means that interest cost will rise and it can lead to situation of bankruptcy. Business risk does impact the cost of equity, if the Firm A has higher business risk than firm B, other things keeping constant then the cost of equity for the firm A would rise because the investor perceive the company riskier.

2) There is no straight formula which can identify what is the optimal debt to equity ratio for a firm but the manager has to estimate the cost of equity and cost of debt with different level of capital structure and the point at which the weighted average cost of capital is least, that is the level which is the optimal level and it will maximize the value of the firm. So, the correct way to identify the optimal capital structure is to calculate the weighted average cost of capital and find the level at which it is least.