What Are Business and Financial Risks Premium?
A risk-free investment was defined as one for which the investor is certain of the amount and timing of the expected returns. The returns from most investments do not fit this pattern.
An investor typically is not completely certain of the income to be received or when it will be received. Investments can range in uncertainty from basically risk-free securities, such as T-bills, to highly speculative investments, such as the common stock of small companies engaged in high-risk enterprises.
Most investors require higher rates of return on investments if they perceive that there is any uncertainty about the expected rate of return. This increase in the required rate of return over the NRFR is the risk premium (RP). Although the required risk premium represents a composite of all uncertainty, it is possible to consider several fundamental sources of uncertainty
Business risk is the uncertainty of income flows caused by the nature of a firm’s business. The less certain the income flows of the firm, the less certain the income flows to the investor.
Therefore, the investor will demand a risk premium that is based on the uncertainty caused by the basic business of the firm.
As an example, a retail food company would typically experience stable sales and earnings growth over time and would have low business risk compared to a firm in the auto industry, where sales and earnings fluctuate substantially over the business cycle, implying high business risk.
Financial risk is the uncertainty introduced by the method by which the firm finances its investments. If a firm uses only common stock to finance investments, it incurs only business risk.
If a firm borrows money to finance investments, it must pay fixed financing charges (in the form of interest to creditors) prior to providing income to the common stockholders, so the uncertainty of returns to the equity investor increases.
This increase in uncertainty because of fixed-cost financing is called financial risk or financial leverage and causes an increase in the stock’s risk premium.
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