Cost of capital refers to the amount of capital used to finance a business.
The cost of capital usually depend on the mode of finance that has been used.
For instance if the business is financed solely through debt, then that is referred as cost of debt. On the other hand, if the business is financed through equity, then that is referred to as cost of equity.
In most cases, companies usually use a combination of both equity and debt to finance their business. Cost of capital usually represent the hurdle that the company or business must overcome in order to generate profit and as a result, it is usually used in capital budgeting to determine if the company or business should proceed with the projects or not.
The cost of capital sources usually varies from business to business depending on factors such as profitability, credit worthiness, operating history among many others.
This means that businesses which are still new have higher cost of capital than businesses that have already established themselves on the market.
In this article, we are going to focus on factors that affects cost of capital in businesses.
1. Current economic conditions
If current economic conditions are good, financial institutions can easily give loans at lower interest to companies.
This will in turn lower the company’s debt which is actually part of cost of capital. On the other hand, if there is a big recession in the market, many financial institutions will give loan at high interest rate meaning that the company’s debts will increase, increasing the cost of capital.
Therefore, if there is stability in the market, the cost of equity capital will increase and cost of debt will decrease.
2. Current dividend policy
Every business has its own dividend policy. The business must determine the total amount of earning that is willing to pay as dividend.
It is therefore very important to understand the concept of price earning ratio. If the price earning ratio increases, they cost of retained earnings will decrease. This is because the money that has been retained to be used to promote the business will be subtracted.
3. Financial and investment decisions
The financial and investment decision that a company makes also affects the cost of capital.
For instance, when a company gets new debt or share capital, it will have to inform the investor about the usage of that particular fund.