As the company includes more and more debt to its capital structure the rate of Return required by the company increases. WACC which comprises of weighted average of cost of Debt and cost of Equity increases as the firm is exposed to more and more debt. The increase in debt increases the risk of the company and as the debt to equity ratio in a capital structure of the firm increases the Return on Equity required by the firm increases which increases the WACC for the firm. This will also increase the amount of earnings required by the firm to keep its value to its previous position.
This risk inherent for an organization due to its operations is called business risk. It is the risk of a firm when it uses no debt. Technically or in terms of formulation it is the uncertainty in the future returns on assets of a firm (ROA). We can write ROA as:
This gives us a way to measure the business risk of an un-levered firm i.e. measuring deviations in the ROE of that firm. Such a business risk is called firm's Basic Business Risk. "Business risk is the uncertainty associated with operating cash flows of a business. There are different dimensions of business risk, namely sales risk and operating risk (mtholyoke, 2007)".
Variations in business risk not only depend on the type of industry a firm is operating in but also varies within the industry from firm to firm. Business risk's dependence is influenced by six common factors.
a) Demand Variability the more the variations in demand of a firm's product, the more will be its business risk
b) Sales Price Variability firms which operate in a market where prices are stable faces low business risk as compared to the firms which operate in a highly volatile market.
c) Input Cost Variability the firms who are weak on the supply side and have high variability in input costs are exposed to high risk
d) Adaptability of output prices with changes in input prices the firms which are in command to change their output prices with changes in input prices are less exposed to business risk.
e) Ability to develop new products in a timely, cost effective manner the more the industry requires introduction of new products in market, the more the firm will be exposed to business risk
f) Degree of operating leverage the high the degree of operating leverage the firm is operating at, the more will be its business risk
Operating Leverage the firms which have high degree of operation leverage i.e. a major portion of their operations depends upon fixed cost leaves their firms more exposed to business risk. That means a decline in sales will not decline the cost since major portion of cost is fixed therefore even a smaller decline in sales