How does market risk affect the cost of capital?

The chief way that market risk affects cost of capital is through its effect on the cost of equity. Companies finance operations and expansion projects with either equity or debt capital. Debt capital is raised by borrowing funds through various channels, primarily through acquiring loans or credit card financing. Equity financing is raised by selling shares of common or preferred stock.

A company's total cost of capital includes both the funds required to pay interest on debt funding and the dividends on equity funding. The cost of equity funding is determined by estimating the average return on investment that could be expected based on returns generated by the wider market. Therefore, because market risk directly affects the cost of equity funding, it also directly affects the total cost of capital.

The cost of equity funding is generally determined using the capital asset pricing model, or CAPM. This formula utilizes the total average market return and the beta value of the stock in question to determine the rate of return that stockholders might reasonably expect based on the perceived investment risk. The average market return is estimated using the rate of return generated by a major market index, such as the S&P 500 or the Dow Jones Industrial Average. The market return is further subdivided into the market risk premium and the risk-free rate.

Source : Investopedia