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Business and Financial Environment - Essay Example
Organizations, when operate, face different type of risks. If the organization is financed all through equity, then stockholders will face the risk inherent in the operations of that business which is called the Business Risk. Business risk is influenced by many factors which include Demand Variability, Price Stability, Input Cost Variability, Adaptability of output prices with the changes in input prices, Ability to develop new products and Degree of Operating Leverage…
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. ...