Determine the factors of financial risk by giving example
W. T. L. Company's cost of long-term debt two years ago was 8 percent. This 8 percent was found to represent a 4- percent risk less cost of long-term debt, a 2-percent financial risk premium and a 2- percent financial risk premium. Presently, the risk less cost of long-term debt is 6 percent. How much would you expect W.T. L's cost of debt to be today, presuming that risk structure of the firm's assets (business risk) and its capital structure (financial risk) have remained unchanged? Previous business risk premium of 2 percent and financial risk premium of 2 percent will still prevail because neither of these risks has changed in two years. Adding the 4 percent total risk premiums (that is the 2-percent business risk and 2-percent financial risk premium) to the 6-percent riskless cost of long-term debt results in cost of long-term debt to the W. T. L. Company of 10 percent. In this time-series comparison where financial risk and business risk are supposed to be constant, cost of the long-term funds changes only in response to changes in riskless cost of a given type of funds. Let's now suppose that there is another company, the Plate Company, for which the risk less cost of long-term debt is the same as it is for W. T. L. Plate Company has a 2 % business risk premium and a 4 % financial risk premium due to the high degree of leverage in its financial structure. Though both companies are in the same type of business (and hence have the same business risk premium of 2 percent), the cost of long-term debt to Plate Company is 12 percent (i.e., percent riskless cost of money. Although relationship between lj, b, and t, is presented as linear in Equation A, this is only for simplicity; actual relationship is likely to be much more complex mathematically. The only definite conclusion that can be drawn is that cost of a specific type of financing for a firm is somehow functionally related to riskless cost of that type of financing adjusted for the firm's business and financial risk.
(i.e., that kj = f(r; b, f).
The reader must recognize that the riskless cost of each type of financing, 'I, may differ considerably. Or we can say, at a given point in time the riskless cost of debt may be 6 percent while riskless cost of common stock may be 9 percent. Riskless cost is expected to be different for each type of financing, j. Risk less cost of different maturities of the same type of debt may differ, as longer -term Issues are generally viewed as more risky.