Risk Sensitivity Indicator as Correction Factor for Cost of Capital Rate

Abstract

Cost of capital rate is a result of risk included in cost of debt rates and cost of equity rates. Generally to estimate cost of capital rates with use of CAPM conception, is used information about general risk indicator, known as beta coefficient and relations between debt and equity rates. Such approach in unmodified version, falsely gives the similar results for enterprises from the same sector and with similar levels of debt to equity relations. In paper is presented risk sensitivity indicator conception which allows to differentiate cost of capital rate between more risk sensitive businesses and less sensitive businesses.

The empirical data from Polish enterprises for 2003-2010 years suggests that for Polish enterprises managing teams risk sensitivity grows and it is illustrated by growing liquidity indicators, what is linked with model suggestion about greater risk sensitivity influence on more flexible and more conservative solutions.

Depending on the business type that the given enterprise is doing, sensibility to current assets financing method risk might vary a lot. Character of business also determines the best strategy that should be chosen whether it will be the conservative strategy (situation closer to the first variant) or aggressive one (situation closer to the first variant) or maybe some of the transitional variants similar to the Compromise strategy. The best choice is that with the adequate cost of financing and highest enterprise value growth. This depends on the structure of financing costs.

In this paper, was considered that relation between risk and expected benefits from the current assets decision and its results on financing costs for the firm. The empirical data from Polish firms for 2003-2010 years confirms the presented financial liquidity investment efficiency model assumptions. Future studies should concern at searching new cases testing the model usefulness and identifying the constraints of that model explanations if that exists.

Keywords: risk sensitivity, cost of capital, enterprise value, sensitivity indicator

JEL Classification: G32, G31, D24