Business risk is related to operating features of a firm while financial risk is related to the strategies behind the capital structure of a firm. The former is a type of risk that is outside the control of firms and hardly affected by certain tactics and strategies because business risk is very dynamic and uncertain. On the other hand, the latter involves factors within the scope of managerial control because it arises from borrowed funds the company is bound to pay unlike equity funds. However, they are both under the definition of systematic risk or inherent risks of companies that cannot be reduced by diversification strategies. Business risks includes example such as the sensitivity of competitive structure of an industry to changes in macroeconomic variables such as inflation and interest rates. On the other hand, the more debt a firm has a greater level of financial risk or inability to meet such obligation.
Cost of equity capital is the most complicated component of firm’s cost of capital. It is definition as the rate of return required on a firm’s shares by the investors in the financial markets is also the source of the problem because there is no direct method to discover the require return of investors. In effect, there are two main methods like the constant dividend growth and CAPM that are used to estimate it. The use of the former leads to simplicity and ease of application of deriving the cost of equity which makes it a practical method to consider. But disadvantages arise in its assumptions. One is that the assumption of constant dividend growth which not all companies is doing. Second is deriving the value of a firm by its dividend payments which undermine other indications of growth and stability like investments that caused retained earnings to raise. In addition, data that is used to install growth rate is based on past information which is not appropriate in estimating the future returns of a company.
With these disadvantages comes the capital asset pricing model (CAPM). The systematic risk which comprised of business and financial risks is represented by beta coefficient which is one of the key variables the CAPM. In determining beta, business and financial risks of a company should be studied in order to give a reliable estimate of beta. Beta is important in the formula of CAPM because it serves as the muloutiplier for risk premium attached to a certain class of security. It will determine how an individual security or portfolio return is sensitive on overall market return. CAPM advantages are derived from its ability to include analysis on both dividends and capital gains which are undermined by constant dividend model. In effect, although more complicated, CAPM is a more accurate measure of cost of equity capital. And CAPM heavily relies on scanning business and financial risks to estimate beta coefficient which able to recognize risks unlike constant dividend model.
Calculations as follows for the 2nd and 3rd question
64,000 Less 25,600 38,400 38,400 / 320,000 Therefore the required rate of return is: 12%. 2b. £ 64,000 8,000 72,000 25,600 6,400 Less 32,000 40,000 40,000 / 320,000 Therefore the required rate of return is now: 12.5%. 3a. WACC = 15% x 320k + 9% x 400k 320k+400k 320k+400k = 6.67 + 4.99 = 11.67 3b. 28,800 7,200 36,000 Plus: 30p 48,000 Earnings = 84,000
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