Question

How do diversifiable and nondiversifiable risk affect a company’s cost of capital?

Answer 1

In case of a diversifiable risk the company can eliminate or reduce this risk through diversification of its activities. When the risk is non diversifiable the cost of capital increases since the resource cannot be eliminated really by diversification. Diversifiable risk does not affect the Asset beta or the cost of capital. Non diversifiable risk is also known as systematic risk or volatility. This risk is measured by beta and beta is used in the CAPM model to compute the cost of capital. Thus, the nondiersifiable risk increases Beta and thus the cost of capital.