Before determining what is the firm’s cost of capital, the manager needs to understand some of the major reasons or dependents for the firm’s cost of capital to rise or fall:
Some of the major factors or dependents that may impact the cost of capital are:
Company’s business risk
The higher a firm’s business risk, the higher the investors’ required rate of return and the cost of capital will also increased.
Company’s financial risk
Where a company is highly geared, the lending institutions will consider the firm’s financial risk to be quite high hence would require a higher rate of return from the firm hence increasing the firm’s cost of capital
Size of Financing
Where the firm’s size namely its assets or sales turnover cannot justify the size of financing needs, the lenders will be more cautious and will impose a higher cost of fund which will then increase the company’s cost of capital
Country’s economic conditions
When inflation rate is increasing, cost of doing business is more expensive hence investors and lenders will demand a higher rate of return which results in a higher cost of capital. When the economy is on its upbeat trend where demand for funds increases and supply of funds are limited or not increasing proportionately to demand then the lenders and financiers increase their lending rate which will also increase a firm’s cost of capital
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