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The purpose of this paper is to investigate the effect of business and financial risk in order to determine the level of systematic risk. Both Modigliani and Miller (MM) (1966) theory and the Capital Asset Pricing Model (CAPM) (Sharpe 1963) provide mechanisms for the evaluation of stock returns as a function of systematic risk. In the CAPM, beta coefficient is an index of systematic risk (see for example Fama & French, 1992; Fama, 1970; Gahlon & Gentry, 1982; Gonedes, 1975; Lev, 1974; Levy, 1971; Rosenberg & McKibben, 1973). Theoretically, systematic risk is determined by business risk and financial risk. According to the corporate trade-off hypothesis (CTH), as noted by Mandelker and Rhee (1984), operating and financial leverage can be combined in a number of different ways to obtain the desirable level of risk of the common stock. Sekara, Gowrib and Ramyac (2014) agree that, excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio. Jordan, Ross, and Westerfield (2007) explain that companies with a lower probability of facing financial distress ought to be able to borrow more than those with a greater probability of facing financial distress. Burrow et al. (2006) further explain that degree of operating leverage and degree of financial leverage are the tools to measure business risk and financial risk respectively, while the degree of combined leverage is the tool to measure the whole risks. Financial leverage can be considered as one among many factors that affect business risk according to Dinh Tran and Ngoc Huy (2015). High business risk can be offset by low financial leverage and vice versa. The static trade-off theory implies that firms should balance tax advantages to be gained from debt with the costs of financial distress (earnings volatility, bankruptcy costs) (Hillier et al., 2011). Additionally, a more successful firm will take on more debt because the firm can reduce the taxes from its higher earnings due to the extra interest (Deesomsak et al., 2004; Hillier et al., 2011). Trying to find the optimal capital structure and maximize firm’s value they trade off the benefits of debt financing again bankruptcy costs and high-interest rates. Anupam and Banerjee (2015) agree that business risk is Abstract

Corporate trade-off hypothesis: An investigation of relationship between business and financial risk