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What is Levered Cost of Equity?
The levered cost of equity represents the risk components of the financial structure of a firm. To finance the projects of a firm, companies often need to resort to debt that is collected from the market. The market offers the debt by the resources of the investors.
In case of levered cost of equity, the firms have larger debt proportions, and hence the firms must convince the investors that it is capable to provide the business and financial risk premiums.
In general, when a company uses unlevered cost of equity, it does not go for debts from the market. It uses the funds it has in its storage for funding a project. So, when it goes to the market, its position is considered better than the unlevered cost of equity holding companies.
Since the proposition offered by unlevered equity holding companies is stronger, investors usually do not ask for risk premiums.
The situation for unlevered cost of equity holding companies is just the reverse. They are mostly funded by debt and has both business and financial risks. To compensate for the risks, the investors ask for more rewards. This reward is to be paid in the form of business and financial risk premiums to the investors.
Risk Premium for Additional Risk
The general principle of capital markets is that, when one bears more risks, he or she must be compensated more for the additional risks. The risks can be of various types. For example, risks can be systematic or non-systematic. The risks may be controllable or uncontrollable by the firms.
In situations where there is a risk, the investors will invest their money when they get additional returns for bearing the risks. This is reflected as financial and business risk premiums.
Therefore, we may write −
$$\mathrm{Cost\:of\:Equity = \mbox{Risk-Free}\:Rate\:+\:Business\:Risk\:Premium\:+\:Financial\:Risk\:Premium}$$
The risk-free rate here is the minimum return that must be paid by the company.
Business risk premiums and financial risk premiums are different in the sense that the financial risk premiums are related to the financial obligations such as debt and equity, while the business risk premiums are for the business operations of a company. A firm that wants to source its projects by market investments therefore must pay both of these premiums to woo the investors.
The investors will only tend to invest in a company if it can assure that there are extra payouts for bearing the risks. If the company does not pay business and financial risk premiums, then no investor will tend to invest money in the company’s projects.
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