Factors Affecting Cost of Capital Accounting Education

Secondly, the market prices of the shares will not remain constant as the shareholders will expect capital gains as a result of reinvestment of retained earnings. Thirdly, all the earnings may not be distributed among the share­holders by way of dividend. Similarly, inflation is expected to deteriorate the purchasing power, investors require a higher rate of return to compensate for this anticipated loss. It is influenced largely by the amount of fixed costs that are incurred by a firm.

The term cost of capital is used by analysts and investors, but it is always an evaluation of whether a projected decision can be justified by its cost. Investors may also use the term to refer to an evaluation of an investment’s potential return in relation to its cost and its risks. Companies in the early stages of operation may not be able to leverage debt in the same way that well-established corporations can. Limited operating histories and assets often force smaller companies to take a different approach, such as equity financing, which is the process of raising capital through selling company shares.

Also there is many regulatory compliance and license to be procured before setting up a manufacturing plant or hospital. This is positive for the industry as it will discourage new entrants and if some new players enters the market than it will take time to set-up and operate. These would vary from time to time – both due to changes in legislature and due to changes in the particular tax bracket the company ends up in. Countries which adopt a flat-tax-rate policy have a much more predictable tax burden, and thus WACC is easier to calculate in a predictive manner. Each financial year, the managers of the company calculate these costs and forwards the information to the owner so that the payments could be made.

Top-down External Factors

The
investors may also like to add a premium with reference to other factors. One
such factor may be the liquidity or marketability of the investment. Higher the
liquidity available with an investment, lower would be the premium demanded by
the investor. If the investment is not easily marketable, then the investors
may add a premium for this also and consequently demand a higher rate of
return.

Capital Structure refers to the proportion of debt and equity used for financial business operations. The firm’s overall cost of capital is based on the weighted average of these costs. Cost of capital is a company’s calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project, such as building a new factory. Factors affecting a company’s capital cost can either be top-down or bottom-up.

The cost of capital is affected by a number of factors. Some are beyond the firm’s control, but…

If the risk-free interest rate was 2% and the default premium for the firm’s debt was 1%, then the interest rate used to calculate the firm’s WACC was 3%. If the Fed raises rates to 2.5% and the firm’s default premium remains 1%, the interest rate used for the WACC would rise to 3.5%. Underwood operates with higher leverage, as indicated by a higher net debt-to-EBITDA, than Gasolina (3.5 versus 3.0) and a lower IC ratio. The cost of equity of a company comprises the sum of the equity risk premium and the benchmark risk-free rate. One common method is adding your company’s total interest expense for each debt for the year, then dividing it by the total amount of debt. High bargaining power of Suppliers – The suppliers of goods and services includes doctors, equipment and drug manufacturer.

• Gasolina’s lower leverage (3.0 versus 3.5) and a higher IC ratio will lead to a lower cost of capital.
• The capital structure affects your business finances and is yet another factor which can alter your WACC.
• In business, cost of capital is generally determined by the accounting department.
• The Net Proceed is that amount which is actually realized after adjusting discount or premium on the face value of loan or debentures after charging floatation costs.
• According to the point of view of an enterprise, the cost of capital refers to the cost of obtaining funds—debt or equity—to finance an investment.
• Businesses and financial analysts use the cost of capital to determine if funds are being invested effectively.

I believe that in current scenario additional cost needs to be absorbed between suppliers and hospitals, as end customers may not be able to absorb it considering decreasing income levels. High industry concentration will have positive impact on cost of debt fund. However this LOW bargaining power is off-stetted by low paying capacity of the patients and price reduction pressure from Insurance companies and government price cap regulations.

Cost of Capital vs. Discount Rate

The economic conditions in the form of demand and supply of capital as well as expectations with respect to inflation also affect 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. It is one of the important factors that influence the determination of cost of capital.

In this method, cost of equity share capital is found by making appropriate adjustments in the current rate of dividend on the basis of probable rate of increase in future earnings of the company. If the debt content in the capital structure of a company exceeds the optimum level, the investors start considering the company as too risky and their expectations from equity shares increase. It is a component of capital structure e.g., debentures, preference shares & equity shares, etc. It refers to the cost of funds intended to finance the expected project. All financial decision making expected rate of return and expected (Future) cost of capital are considered. Future cost are widely used in capital budgeting and capital structure designing decisions.

The capital structure affects your business finances and is yet another factor which can alter your WACC. If we are using the IRR method, then the WACC, calculated above, should be compared with the IRR of the project. If the project IRR is greater than the WACC, the project should be accepted.

Introduction to Cost of Capital

Therefore, cost of capital refers to the minimum rate of return a firm must earn on its investment so that the market value of equity shares remains unchanged. It serves as a guideline to determine the rate at which the firm shall borrow the funds. It can be concluded that the capital structure represents the percentage of debt to equity in the capital structure. The capital structure of the business impacts the profitability and financial risk of the business. It is very difficult to define what kind of capital structure is best for a business.

It’s difficult to pinpoint cost of equity, however, because it’s determined by stakeholders and based on a company’s estimates, historical information, cash flow, and comparisons to similar firms. Companies competitive positioning – Again focus will be here on market share stability, track record and operating effectiveness. Companies with stable growth, revenue and track record will definitely able to increase investor confidence and hence reduce cost of capital.

In some cases, this is why companies only reissue common stock with voting rights as preferred shares are only issued when more money is needed for major business projects. The last factor that can greatly affect a company’s cost of equity capital is the dividend growth rate expected for preferred shares. This growth rate indicates the amount of money a company will continue to pay out to investors holding preferred shares.

In case of the net present value method, the cost of capital is used as the discounting rate for discounting the future inflow of funds. Any project resulting into positive net present value only will be accepted. Explicit cost is the one which is attached with the source of capital explicit or apparently. In case of the debt capital, the interest which the company is required to pay on the same is explicit cost of capital. In order to minimize its average cost of capital, a company needs to judiciously combine different sources of finance in order to reach its optimal capital structure.

• As the Fed makes adjustments to interest rates, it causes changes in the risk-free rate, the theoretical rate of return for an investment that has no risk of financial loss.
• Each financial year, the managers of the company calculate these costs and forwards the information to the owner so that the payments could be made.
• A higher rate of corporate tax makes the debt funds cheaper because of the tax shield enjoyed by interest.
• Even some arguments are given in favour of marginal cost, specific cost and composite cost.

In all cases, net Program Fees must be paid in full (in US Dollars) to complete registration. We expect to offer our courses in additional languages in the future but, at this time, HBS Online can only be provided in English. Industry will see more negative covenants in terms of restrictions to use the funds, involvement in decision making, seniority factors affecting cost of capital ranking etc will be rising in the indentures. Floatation costs include all types of charges or expenses incurred to obtain such loan like – Advertisements Charges, Postage Stationery & Printing, Stamp duty, Brokerage Underwriting commission etc. After submitting your application, you should receive an email confirmation from HBS Online.

Alternatively, an expert may choose an industry average capital structure. This is typically more relevant when valuing a controlling interest in the business or when calculating lost profits. When using WACC as the discount rate in a DCF analysis, a valuator can choose various capital structures. What’s appropriate depends on the characteristics of the company and the standard of value being applied. Financial analysis, balance sheet position will be analysed before arriving decision on credit risk of the Company. I am not going to touch more on this as this only reflects the history and management ability for sustainable business.

Capital structure decisions involve determining the types of securities to be issued as well as their relative share in the capital structure. The financial decision regarding the composition of the capital structure is made after the financial requirements have been established. It entails determining how much money should be raised from each source of funding. In short, capital structure decisions involve determining the type of securities to be issued and their relative capital share. The weighted average cost of capital represents the average cost of the company’s capital, weighted according to the type of capital and its share on the company balance sheet. This is determined by multiplying the cost of each type of capital by the percentage of that type of capital on the company’s balance sheet and adding the products together.

The higher the taxes, the lower is the cost of capital and the lower the tax, the higher is the cost of capital. One can calculate the weighted average cost of capital of their business using WACC calculator available on various reputed websites on the internet. These online calculators are effective and can calculate your WACC accurately.