Positive correlation

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There is a typically a positive correlation (a relationship between two variables in which both move in the same direction) between risk and return. However, correlation does not guarantee that taking greater risk results in a greater return. Taking greater risk may result in a larger amount of capital. A more correct statement may be that there is a positive correlation between the amount of risk and the potential for return. Generally, a lower risk investment has a lower potential for profit. A higher risk investment has a higher potential for profit but also a potential for a greater loss (Segal, 2021). The textbook explains a model of valuation called the dividend discount model which helps describe that the valuation of a stock is simply the “present value of the expected future cash flow stream” (Besley S., & Brigham E., 2016). Additionally, the value of a stock over a period is concerned with the dividends received. Factoring in risk, generally a stock with a higher risk could be expected to pay higher dividends.

        Just like an individual seeking credit, the riskier a firm is, the costlier their debt would be in the form of higher interest rates. Firms commonly seek bonds and loans to fund their operation and if a firm is new or generally perceived as risker, companies providing loans would seek a high interest rate, or a firm would have to offer their corporate bonds with a high rate to attract investors. 

        Capital structure highlights the proportion of debt and equity used for financing the operations of business. Each firm is different, and the “ideal” capital structure will vary by firm. However, the ideal capital structure should be one that “…increases the value of equity share or maximizes the wealth of equity shareholders” (Samishka, n.d.). Since debt is considered riskier than equity, but equity is generally more expensive than debt. While there are many factors to capital structure, some factors to consider for capital structure are a) cash flow position, b) interest coverage ratio, and even c) control of the firm. Since a firm is required to pay back their debts to continue to operate, they may seek a higher debt ratio if they have stable, high cash flows. Interest coverage ratio (ICR) is calculated as EBIT/Interest. A high ICR means companies can have more borrowed funds since they can theoretically afford their interest obligations. Since equity shareholders have voting rights in a firm, the more a firm uses equity to fund their operations, they are directly giving up voting rights (control) of the firm. Debtholders have no voting rights, so balancing these is important if the firm doesn’t want to give up too much control of their organization.

Financial risk is a firm’s ability to manage debt and financial leverage, while business risk is a firm’s ability to generate sufficient revenue to cover its operational expenses. For example, financial risk refers to the risk of a firm not generating cash flow and defaulting on debt payments and business risk as the risk that the firm will be unable to generate revenue to be profitable. Some types of expenses that are concerned with business risk are salaries, production costs, facility rent, office, and administrative expenses (Maverick, 2021). Despite these differences, both financial and business risk require a firm to generate revenue to fund operations, and they require a balance to be used effectively. As discussed within capital structure, a firm is lower cash flows may not focus their structure on debt and instead look towards equity in the form of stock. However, if a firm cannot generate cash flows to become profitable, they will have difficulty finding investors and may not be able to raise the desired level of funding for the firm.

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