A 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.

Besley S., & Brigham E. (2016). CFIN. [South University]. Retrieved from https://digitalbookshelf.southuniversity.edu/#/books/9781305888036/

Maverick, J. (2021, July 25). Corporate Finance & Accounting. Retrieved from Investopedia: https://www.investopedia.com/ask/answers/062315/what-are-key-differences-between-financial-risk-and-business-risk-company.asp

Samishka. (n.d.). Factors affecting the Capital Structure of a Company. Retrieved from Your Article Library: https://www.yourarticlelibrary.com/economics/market/factors-affecting-the-capital-structure-of-a-company/8752

Segal, T. (2021, June 25). Portfolio Construction . Retrieved from Investopedia: https://www.investopedia.com/ask/answers/040715/there-positive-correlation-between-risk-and-return.asp

Tuovila, A. (2021, September 4). Capital Structure. Retrieved from Investopedia: https://www.investopedia.com/terms/c/capitalstructure.asp



A positive correlation exists between risk and return: the greater the risk, the higher the potential for profit or loss. A firm must compare the expected return from a given investment with the risk associated with it. Higher levels of return are required to compensate for increased levels of risk. In other words, the higher the risk undertaken, the more ample the return – and conversely, the lower the risk, the more modest the return

Capital Structure can be a mixture of a company’s long-term debt, short- term debt, common stock and preferred stock. A company’s proportion of short-term debt versus long-term debt is considered when analyzing its capital structure. Some primary factors that should be considered when establishing capital structure are cost, risk and the type of investments. Cost, being the first factor that should be considered when a shareholder invest money in a company, there is no promise of a specific interest rate. However, the annual rate of profitability that investors expect from the company is the implicit cost of shareholder funds. If the company fails to provide this type of profitability, the shareholders will likely attempt to withdraw their investments and take their funds elsewhere. Risk plays as a factor because the greater the risk of a business proposition, the more sense it makes to finance it via shareholder funds. Should the expected profits not materialize, shareholders can, at worst, attempt to sell their shares. As long as one shareholder sells her shares to another, the company suffers few ill consequences. Should the shareholder be disappointed with his investment and attempt to sell his shares to the company, the company can refuse to buy those shares. However, if the company fails to make enough money to repay its loans, the borrowers can sue the company and, in extreme cases, confiscate its assets. If the company foresees such a risk.

The longer it will take for an investment to pay off, the more sense it makes to rely on shareholder funds, as opposed to loans. Even at fairly modest interest rates, the compounded interest expense over a long period of time will be a significant burden for the company. Such long-term investments are best financed through shareholder funds. To ensure that the company moves in the right strategic direction, such shareholders often assume an active role in the management of the company.

Financial risk and business risk are two different types of warning signs that investors must investigate when considering making an investment. Financial risk refers to a company’s ability to manage its debt and financial leverage, while business risk refers to the company’s ability to generate sufficient revenue to cover its operational expenses. An alternate way of viewing the difference is to look at financial risk as the risk that a company may default on its debt payments and business risk as the risk that the company will be unable to function as a profitable enterprise

Risk and Return, A highly correlated relationship, (2021) Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/risk-and-return/

Target Capital Structure, (2020, August 9) Small Business. https://smallbusiness.chron.com/factors-considered-setting-target-capital-structure-68469.html


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