Cost of capital, like all other costs, is a variable term, subject to changes in a number of factors. The various factors that play a part in the determination of the cost of capital are described below. There are four main factors that mainly determine the cost of capital of a firm.
1. General Economic Conditions
General economic conditions determine the demand for and supply of capital within the economy, as well as the level of expected inflation. This economic variable is reflected in the riskless rate of return. This rate represents the rate of return on risk-free investments, such as the interest rate on short-term government securities. In principle, as the demand for money in the economy changes relative to the supply, investors alter their required rate of return. For example, if the demand for money increases without an equivalent increase in the supply, lenders will raise their required interest rate. At the same time, if inflation is expected to deteriorate the purchasing power of money, investors require a higher rate of return to compensate for this anticipated loss.
2. Market Conditions
When an investor purchases a security with significant risk, an opportunity for additional returns is necessary to make the investment attractive. Essentially, as risk increases, the investor requires a higher rate of return. This increase is called a risk premium. When investors increase their required rate of return, the cost of capital rises simultaneously. If the security is not readily marketable when the investor wants to sell, or even if a continuous demand for the security exists but the price varies significantly, an investor will require a relatively high rate of return. Conversely, if security is readily marketable and its price is reasonably stable, the investor will require a lower rate of return and the company’s cost of capital will be lower.
3. Operating and Financing Decisions
Risk, or the variability of returns, also results from decisions made within the company. Risk resulting from these decisions is generally divided into two types: business risk and financial risk. Business risk is the variability in returns on assets and is affected by the company’s investment decisions. Financial risk is the increased variability in returns to common stockholders as a result of financing with debt or preferred stock. As business risk and financial risk increase or decrease, the investor’s required rate of return (and the cost of capital) will move in the same direction.
4. Amount of Financing
The last factor determining the corporation’s cost of funds is the level of financing that the firm requires. As the financing requirements of the firm become larger, the weighted cost of capital increases for several reasons. For instance, as more securities are issued, additional flotation costs, or the cost incurred by the firm from issuing securities, will affect the percentage cost of the funds to the firm. Also, as management approaches the market for large amounts of capital relative to the firm’s size, the investors’ required rate of return may rise. Suppliers of capital become hesitant to grant relatively large sums without evidence of management’s capability to absorb this capital into the business. This is typical “too much too soon”. Also, as the size of the issue increases, there is greater difficulty in placing it in the market without reducing the price of the security, which also increases the firm’s cost of capital.