Business risk is the risk associated with a firm’s operations. It is the undiversifiable volatility in the operating earnings (EBIT). Business risk is affected by the firm’s investment decisions. A measure for the business risk is the asset beta, also known as the unlevered beta. The return on assets of a firm can be expressed as a function of the risk-free rate and the business risk premium (BRP):
rA = rF + BRP
Financial risk is associated with the firm’s capital structure and magnifies the business risk of a firm. Financial risk is affected by the firm’s financing decision.
Total corporate risk is the sum of the business and financial risks and is measured by the equity (levered) beta. The business risk premium (BRP) and financial risk premium (FRP) are reflected in the levered (equity) beta, and the return on levered equity can be written as:
rE = rF + BRP + FRP
Debt beta is a measure of the risk of a firm’s defaulting on its debt. The return on debt can be written as:
