Solution

Abstract

This report critically analyzes how risk and the cost of capital are linked among firms in Saudi Arabia, with particular emphasis on the different roles played by systematic and unsystematic risks. It looks into known financial theories such as Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT), and evaluates their application to the Gulf financial markets. The report examines the sector-specific risks, specifically within the oil and banking sector, and how they affect the cost of capital of particular firms, as well as the distinctive risk-return dynamics of Sharia-compliant finance structures. An analysis of empirical literature points towards the pricing of risk in emerging markets and reforms that need to be undertaken with respect to markets that are highly volatile and have concentrated ownership structures. Chosen case studies of major Saudi companies illustrate the influence of the market risk, sector exposure, and regulatory restrictions on corporate financial strategies. The report sums up by making recommendations on financial policy enhancement and risk management activities that comply with Vision 2030 policies of Saudi Arabia.

Contents

1.0 Introduction. 3

2.0 Background. 4

3.0 Research Objectives 5

4.0 Literature Review.. 6

4.1 Effects of Systematic and Unsystematic Risks on the Cost of Capital for Firms in Saudi Arabia  6

4.2 Review of Key Theories: CAPM and APT. 6

4.3 Empirical Evidence on How Gulf Financial Markets Price Risk. 7

4.4 Influence of Sector-Specific Risk on Cost of Capital 8

4.5 Influence of Sharia-Compliant Finance on Risk-Return Dynamics 9

5.0 Review of Selected Cases 10

6.0 Key Findings. 11

7.0 Conclusion and Recommendations. 12

7.1 Conclusion. 12

7.2 Recommendations 13

References 14

1.0 Introduction

The cost of capital is an important concept in corporate finance because it helps shape investment, financing and overall business strategy decisions at the firm level. Following a definition provided by Kurniasih et al. (2022), it is the minimum that a company has to provide in its returns so that the company could please its investors and stay economically stable. One of the influencing factors of cost of capital is risk, which impacts on both the returns that an investor would demand, and the circumstances in which companies can obtain capital. Here, risk is commonly categorized into two main categories namely: systematic and unsystematic risks whereby, systematic risk, as defined by Renn et al. (2020), impacts the market or economy at large and unsystematic risk impacts only firm, industry, or sector (Roman, 2019).

It is particularly crucial to determine the correlation between risk and cost of capital in new and dynamic markets like the Saudi Arabian market. Due to significant economic changes that the country is undertaking under its Vision 2030 plan, which is expected to promote economic diversification and limit reliance on oil, as well as stimulate the development of the country to focus on the role of the private sector, the financial markets are changing (Khoirunnisa & Nurhaliza, 2024). The emergence of new investment opportunities, regulatory changes as well as greater openness of the markets have all influenced the manner in which risk is perceived and priced. The financial system in Saudi Arabia is also exceptional, as it incorporates conventional finance along with Sharia-compliant financial products with differing risk-return profiles and implications for corporate financing (Boulanouar et al., 2024).

The aim of this report is to explore how different types of risks affect the cost of capital of Saudi Arabian companies. It will begin by evaluating critical financial theories like the Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) and continue with the discussion of risk pricing in Saudi and the Gulf markets. The paper will also be looking at sector specific risk, like the oil and bank sectors, and how Islamic financial principles impact the connection between risk and cost of capital. Lastly, the paper provides conclusions and recommendations, based on the findings.

2.0 Background

The connection between risk and the cost of capital has been a major concern in financial management and it determines how firms acquire funds, invest their resources, and pursue investment opportunities. Kurniasih et al. (2022) explain that a cost of capital is a reflection of expected returns of those who provide funds to a company, either in the form of equity, debt, or other instruments. Saalmuller (2022) also states that it acts as a measure or standard by which companies test the viability of possible projects. One key element of this computation is the risk that is involved in the operations of the firm and the market environment in general. Rao et al. (2022) assert that the greater the perceived risk by investors, the higher the returns they demand to unlock the capital, and subsequently, there are impacts on the cost of raising capital by a company.

Risk that influences the cost of capital of a firm can be classified either as systematic or unsystematic. Systematic risk (also known as market risk) is caused by external situations like inflation, interest rate fluctuations, oil prices and political stability, which impact all the companies in an industry to a certain extent (Renn et al., 2020). Unsystematic risk is, by contrast, caused by factors unique to a firm or industry, such as, management, operational, or competition. Although unsystematic risk is addressed through diversification, systematic risk is mostly unavoidable and of primary concern to the investors and financial managers (Roman, 2019).

These risks are especially dominant in the Saudi Arabian context, given its economic system and other current reforms with Vision 2030. Historically dependent on the oil industry, Sarwar (2022) notes that the economy is currently experiencing massive reforms as a way to encourage diversification, enhance regulatory systems, and attract foreign investment. Furthermore, how risk is measured and priced is complicated by the existence of conventional and Sharia-compliant systems of finance (Nugroho, 2023). All these aspects necessitate a review of the influence of various risks on the cost of capital in the Saudi firms, especially in the major sectors such as oil, banking and real estate.

3.0  Research Objectives

1. To critically examine the relationship between financial risk and the cost of capital for firms in Saudi Arabia, focusing on how both systematic and unsystematic risks influence financing decisions and investment strategies in an emerging market context.
2. To review and assess key financial theories, including the CAPM and the APT, analyzing their assumptions, limitations, and applicability to capital markets in Saudi Arabia.
3. To evaluate empirical studies and evidence on how risks are priced in Gulf financial markets, with particular attention to factors such as market volatility, ownership structures, and economic dependency on specific sectors like oil and banking.
4. To explore the impact of sector-specific risks on the cost of capital, identifying how industries such as oil, banking, and real estate manage financial risk and determine their capital structure and financing costs.
5. To investigate how Sharia-compliant financial products and principles affect risk-return dynamics and influence the cost of capital for firms, considering the unique features and restrictions of Islamic finance compared to conventional financial systems.
6. To provide conclusions and recommendations for financial managers, policymakers, and investors, offering insights into effective risk management and capital cost strategies in light of ongoing economic reforms under Saudi Arabia’s Vision 2030.

4.0 Literature Review

4.1 Effects of Systematic and Unsystematic Risks on the Cost of Capital for Firms in Saudi Arabia

Risk is an important element in corporate finance because it influences the costs of capital through the determination of the level of expected returns desired by the investors. In relation to Saudi Arabia, both the risk types contribute greatly to the cost of capital. The systematic risks are particularly prominent since the economy heavily relies on oil and the government is undertaking economic reforms under the vision 2030 (Asafo-Adjei et al., 2022). For example, the Saudis stock market has always been highly volatile due to the changing global…..

Please click the following icon to access this assessment in full