Cost of Capital^29
rj = the riskless cost of the given type of financing, j
b = the business risk premium
f = the financial risk premiumEquation 2 indicates that the cost of each specific type of capital depends on he riskless
cost of that type of funds, the business risk of the firm, and the financial risk of the
firm.
Since the firmís business and financial risk are assumed to be constant, the changing
cost of each type of capital, j, over time should be affected only by changes in the
supply of and demand for each type of funds, j. The cost of each type of capital to
a given firm compared to the cost to another firm (i.e., the inter firm comparison) can
differ because of differences in the degree of business and financial risk associated
with each firm, since the riskless cost of the given type of funds remains constant.
Different business and financial risk premiums are associated. with different levels of
business and financial risk. These premiums are a function of the business risk, b, and
financial risk, f, of a firm. For intra firm (i.e., time series) comparisons, the only
differentiating factor is the cost of the type of financing, since business and financial
risk are assumed to be constant An example may help to clarify these points.
Example
The W.T. L. Companyís 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- petcent financial risk premium. Currently, the
risk less cost of long-term debt is 6 percent. How much would you expect the W. T.
L.ís cost of debt to be today, assuming that the risk structure of the firmís assets
(business risk) and its capital structure (financial risk) have remained unchanged? The
previous business risk premium of 2 percent and financial risk premium of 2 percent
will still prevail, since neither of these risks has changed in two years. Adding the 4
percent total risk premiums (i.e., the 2-percent business risk and the 2-percent financial
risk premium) to the 6-percent riskless cost of long-term debt results in a cost of long-
term debt to the W. T. L. Company of 10 percent. In this time-series comparison,
where business risk and financial risk are assumed to be constant, the cost of the long-
term funds changes only in response to changes in the riskless cost of a given type of
funds.
Let us 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. The Plate Company
has a 2-percent business risk premium and a 4-percent financial risk premium because
of the high degree of leverage in its financial structure. Although both companies are
in the same type of business (and thus have the same business risk premium of 2
percent), the cost of long-term debt to the Plate Company is 12 percent (i.e., the
dpercent riskless cost of money.
Although the relationship between lj, b, and t, is presented as linear in Equation A, this
is only for simplicity; the actual relationship is likely to be much more complex
mathematically. The only definite conclusion that can be drawn is that the cost of a