Essay on factors determining cost of capital
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1. Current Economic Conditions
If banks are growing, they can easily give loan at low rate of interest because they need to increase the sale for stability of their products. At that time, company's cost of debt will decrease which is the part of company's cost of capital. Not just bank but whole economic conditions should be ok for this. If there is big recession in the market, no financial institute will decrease the rate of interest because they also have to pay the return to their customers. It means, every loan providing company has also cost of capital. If there will be stability in the market, cost of debt will decrease and cost of equity capital will increase.
2. Current Capital Structure
When we have studied optimal capital structure, we have to study the cost of capital because for optimal capital structure, we need to calculate weighted average cost of capital. But if company did not consider cost of capital as factor, we can include the study of current capital structure as the factor for cost of capital. Current debt equity ratio will effect the cost of capital. If debt is more than share capital, we have to pay more cost of debt. If share capital is more than debt, we have to pay cost of equity or pref. share capital.
3. Current Dividend Policy
Every company has to make dividend policy. What amount of total earning, company is interested to pay as dividend. For this, we have to study Price-Earning Ratio (Dividend/EPS). If Price earning ratio will increase, cost of retained earning will decrease because we will less money which have retained and use for promoting of business as source of fund.
4. Getting of New Fund
Company's new fund's requirement will also affect the cost of capital. If company needs $ 20 million dollars immediately for business promotion, company will have to pay high rate of interest because with this, risk of financial institution will increase. Every loan provider works with patience, he needs to analyze the company before providing big loan. If he will give big loan immediately, it is sure, he will get more return from company and company has to pay more cost of this. Except this, every time, when company will go to market for getting fund, company company will get the money at new market rate. So, company has also to follow new rate of cost of capital. It may increase or decrease company's current cost of capital rate.
4. Financial and Investment Decisions
When we get new share capital or debt, we have to tell to fund providers about the usage of their fund. If there is more risk in the investment, both shareholders and creditors will get high reward for this. So, our financial and investment decisions will effect the cost of capital.
5. Current Income Tax Rates
We know, we charge the interest before tax charges. When we earn money, we deduct our interest charges, then we deduct tax charges. So, if tax rate will high, it will effect the cost of share capital because with high tax charges, our net earn will decrease and it will decrease earning per share. So, we will give less dividend to our shareholders.
6. Breakpoint of Marginal Cost of Capital
Marginal cost of capital is the cost raising one more unit of capital. Its breakpoint will affect the cost of capital. Before studying, how marginal cost of capital affects current cost of capital, we have to understand the breakpoint of marginal cost of capital
Break Point = Amount of Capital at which Sources Cost of Capital Changes/Proportion of New Capital Raised from the Source
Following are main breakpoint
a) Break-point of Debtb)Break-point of Pref. Sharec) Break-point of equity share capital
If banks are growing, they can easily give loan at low rate of interest because they need to increase the sale for stability of their products. At that time, company's cost of debt will decrease which is the part of company's cost of capital. Not just bank but whole economic conditions should be ok for this. If there is big recession in the market, no financial institute will decrease the rate of interest because they also have to pay the return to their customers. It means, every loan providing company has also cost of capital. If there will be stability in the market, cost of debt will decrease and cost of equity capital will increase.
2. Current Capital Structure
When we have studied optimal capital structure, we have to study the cost of capital because for optimal capital structure, we need to calculate weighted average cost of capital. But if company did not consider cost of capital as factor, we can include the study of current capital structure as the factor for cost of capital. Current debt equity ratio will effect the cost of capital. If debt is more than share capital, we have to pay more cost of debt. If share capital is more than debt, we have to pay cost of equity or pref. share capital.
3. Current Dividend Policy
Every company has to make dividend policy. What amount of total earning, company is interested to pay as dividend. For this, we have to study Price-Earning Ratio (Dividend/EPS). If Price earning ratio will increase, cost of retained earning will decrease because we will less money which have retained and use for promoting of business as source of fund.
4. Getting of New Fund
Company's new fund's requirement will also affect the cost of capital. If company needs $ 20 million dollars immediately for business promotion, company will have to pay high rate of interest because with this, risk of financial institution will increase. Every loan provider works with patience, he needs to analyze the company before providing big loan. If he will give big loan immediately, it is sure, he will get more return from company and company has to pay more cost of this. Except this, every time, when company will go to market for getting fund, company company will get the money at new market rate. So, company has also to follow new rate of cost of capital. It may increase or decrease company's current cost of capital rate.
4. Financial and Investment Decisions
When we get new share capital or debt, we have to tell to fund providers about the usage of their fund. If there is more risk in the investment, both shareholders and creditors will get high reward for this. So, our financial and investment decisions will effect the cost of capital.
5. Current Income Tax Rates
We know, we charge the interest before tax charges. When we earn money, we deduct our interest charges, then we deduct tax charges. So, if tax rate will high, it will effect the cost of share capital because with high tax charges, our net earn will decrease and it will decrease earning per share. So, we will give less dividend to our shareholders.
6. Breakpoint of Marginal Cost of Capital
Marginal cost of capital is the cost raising one more unit of capital. Its breakpoint will affect the cost of capital. Before studying, how marginal cost of capital affects current cost of capital, we have to understand the breakpoint of marginal cost of capital
Break Point = Amount of Capital at which Sources Cost of Capital Changes/Proportion of New Capital Raised from the Source
Following are main breakpoint
a) Break-point of Debtb)Break-point of Pref. Sharec) Break-point of equity share capital
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Cost of capital is an important concept in financial management. Various financing and investing decisions depend upon the cost of capital of a firm. There are several factors that make cost of capital of a firm high or low.
Some of the important factors are discussed below:
1. Demand and Supply of Capital:
Demand and supply of capital affects the cost of capital. If the demand for funds in the economy increases, lenders will automatically increase the required rate of return and vice-versa. Supply of funds has an inverse relation to cost of capital: If supply of fund increases then the cost of capital decreases; and if the supply of funds decreases, the cost of capital increases.
2. Market Condition:
The market condition of the product produced by the project for which a fund is required is an important factor for determining the cost of capital. Funds required for risky projects increases the cost of capital, as lenders demand a higher rate to compensate their risk. On the other hand, if the market condition of the products produced by the project is such that it will have a high and secured return, then the risk will be lower and obviously the cost of capital will be less.
3. Unsystematic Risk:
Unsystematic risk is of two types: Business risk and financial risk. Business risk arises due to investment decisions of the company. Financing risk arises due to financing decisions, i.e. proportion of debt and equity in the capital structure. Business risk and financing risk affect the overall cost of capital of a firm. A firm's total unsystematic risk is the sum of business and financing risks. The cost of capital is directly proportional to the total unsystematic risk of the firm.
4. Volume of Financing:
Volume of financing also affects the cost of capital. High volume of capital also increases the overall cost of capital due to issue related costs and the greater risks involved. The liquidity risk associated with high volume of capital also increases cost of capital. If the firm uses lower volume of capital then the suppliers of the fund remain more assured of their fund and the cost of capital reduces.
Some of the important factors are discussed below:
1. Demand and Supply of Capital:
Demand and supply of capital affects the cost of capital. If the demand for funds in the economy increases, lenders will automatically increase the required rate of return and vice-versa. Supply of funds has an inverse relation to cost of capital: If supply of fund increases then the cost of capital decreases; and if the supply of funds decreases, the cost of capital increases.
2. Market Condition:
The market condition of the product produced by the project for which a fund is required is an important factor for determining the cost of capital. Funds required for risky projects increases the cost of capital, as lenders demand a higher rate to compensate their risk. On the other hand, if the market condition of the products produced by the project is such that it will have a high and secured return, then the risk will be lower and obviously the cost of capital will be less.
3. Unsystematic Risk:
Unsystematic risk is of two types: Business risk and financial risk. Business risk arises due to investment decisions of the company. Financing risk arises due to financing decisions, i.e. proportion of debt and equity in the capital structure. Business risk and financing risk affect the overall cost of capital of a firm. A firm's total unsystematic risk is the sum of business and financing risks. The cost of capital is directly proportional to the total unsystematic risk of the firm.
4. Volume of Financing:
Volume of financing also affects the cost of capital. High volume of capital also increases the overall cost of capital due to issue related costs and the greater risks involved. The liquidity risk associated with high volume of capital also increases cost of capital. If the firm uses lower volume of capital then the suppliers of the fund remain more assured of their fund and the cost of capital reduces.
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