Chapter 4

Chapter 4

According to the CAPM, the required return depends only on the nondiversifiable risk of an investment. However, nondiversifiable risk borne by the shareholders can be further split into two parts. It is very important to distinguish between these two types of risk because they affect required returns in different ways.

The main part of nondiversifiable risk is often called business risk or operating risk. Business risk is the inherent or fundamental risk of a business without regard to how it is financed. Business risk comes from operating the business; it is based on the firm’s assets, the left-hand side of its balance sheet.

The secondary part of nondiversifiable risk is called financial risk. Financial risk comes from how the firm is financed; it is based on the firm’s capital structure (its proportions of debt and equity), which is the firm’s liabilities and owners’ equity, or right-hand side of its balance sheet.

In many cases, a firm has few choices about its business risk. It is simply the inherent risk of the investment. By contrast, a firm’s financial risk is determined by the amount of debt it has, its financial leverage, or simply leverage. More leverage increases financial risk.

The term leverage is derived from the mechanical lever that allows you to lift more weight than is possible by yourself. Financial leverage allows shareholders to control (lift, so to speak) more assets than is possible using only their own money. In addition to (financial) leverage there is a second type of leverage, called operating leverage. We now turn to this.

Operating Leverage
Operating leverage is the relative mix of fixed and variable costs required to produce a product or service. Multiple methods of producing a product or service may exist, whereby a firm spends more on fixed costs and less on variable costs, or vice versa. A decrease in the variable cost per unit creates an increase in the contribution margin (the selling price minus the...