The relationship between risk and return

A firm’s capital structure is determined by more than just a component cost for each source of capital and is not fixed over time. Rather, the capital structure of a firm is determined by conditions in the domestic and international economies and it should also reflect changing conditions in the economy. In other words, the relationship between risk and return should be the major consideration in establishing the capital structure of the firm and the value of the firm.

Address all of the following questions in a brief but thorough manner.

What is the basic relationship between risk and return and how is this reflected in the value of the firm’s stock? The cost of debt?
What are the primary factors that should be considered when establishing a firm’s capital structure?
What are the primary differences and/or similarities between financial risk and business risk?

Sample Solution