Financial risk

Financial risk is the uncertainty introduced by the method by which the firm finances its investments. If a firm uses only common stock to finance investments, it incurs only business risk. If a firm borrows money to finance investments, it must pay fixed financing charges (in the form of interest to creditors) prior to providing income to the common stockholders, so the uncertainty of returns to the equity investor increases. This increase in uncertainty because of fixed-cost financing is called financial risk or financial leverage and causes an increase in the stock’s risk premium.