Factors Affecting Cost of Capital Samples †MyAssignmenthelp.com

Question: Discuss about the Factors Affecting Cost of Capital. Answer: Introduction The cost of capital of the firm is an important aspect of the business which is considered by the management of the company. This capital structure of the company decides the cost of capital of the company which is the return that the lender of the long-termfinance is expecting on the money invested by them in the company. The cost of capital is basically their return of the risk taken by them on investing their money in the company. The cost of capital should be minimized by the management of the company. Low cost of capital will decrease the burned on the on those who are in charge with the governance and they can concentrate on expansion of the company. If the cost of capital is on higher side than less proportion of the profit is left for expansion of the company. Impact of cost of capital on the financial performance of the firm The main objective of creating the organization was to earn some profit by carrying out some business activities by it. The profit earning depends on various factors of the organizations like the quality of the product or services rendered by it, competition in the market, minimizing the cost of carrying out the business activities. The cost of carrying out business is made of different costs like cost of manufacturing, cost of marketing and cost of capital of the firm. The management can increase the profit of the business by simply decreasing the cost of capital of the organization. The cost of capital can be lowered by the management of the company or those who are in charge with the governance by determining the suitable capital structure for the company(S, 2016). Cost of capital is the cost incurred by the company on using the borrowed funds of the outsiders. An organization does not have sufficient resources and funds to carry out the large business activities of the company. The organization has to borrow funds available in the market. For using such funds company has to pay some cost in the form of interest or dividends to the lenders of the funds. Different types of funds are available in the market which has different cost of capital and other characteristics associated with them that have to be considered by the management of the company before borrowing any funds. The equity shares are a cheap source of funds that can be used for raisingfinance from the company but there is the distribution of power to control the company along with each distribution of the equity shares. The equity shares do not have a legal obligation for payment of interest or dividend to the equity shareholders. The equity shareholders are the owner of the company and will be paid dividend out of the profit earned by the company earned during that financial year. If there is no profit for the company the no dividend will be paid to the equity shareholders(Vatavu, 2105). However, in case of a debenture or other long term or short loan is taken from any bank or any financial institution, there is a legal obligation to pay these cost interest irrespective of the fact that there is profit earned in that financial year by the company. This interest paid by the company to the debenture holder or the financial institution will be shown as an expense in the statement of profit and loss account, therefore, will decrease the revenue of the company which will be taxed by the government authorities. This means that it helps in reduction of the tax payable by the company which the equity shares fail to do(Nirajini, 2013). Therefore the selection of the capital structure is the very important procedure for the financial performance of the company. A company cannot raise too muchfinance from the equity shares because it will distribute the control of the company in large proportion despite the fact that it is less risky option from raisingfinance from other long term financial source. In the same way, a company cannot raise too much finance from the debentures and financial institution available in the market because the capital structure will be too risky and the legal obligation to pay interest will increase which will increase the cost of capital too much. Different theories are available on the market that will help in indenting the best capital structure of the company that will keep the cost of capital on lower side. Some of them are listed as follows: Modigliani and Millers Approach Pecking Order Theory Trade-Off Theory Agency Theory. Factors to be considered while determining the cost of capital of the company The capital structure of the company should be a proper mix of debt and equity financing options. The capital structure should be designed as such that it will contribute to least cost of capital for the company. There are various factors which have to be kept in mind while deciding the capital structure of the company. Some of the major factors that can influence the decision regarding the capital structure of the company are as follows: Market condition: the Current market condition is an important factor that has to be kept in mind while deciding the capital mix for the purpose of raising finance. The market can be volatile and if the company is suffering from any scarcity of demand for the product it is manufacturing or selling than the lender will accept high return for taking on investing in the firm. The external market condition such as if the financial companies are growing then they can provide finance to the company at a comparatively lower rate. This will then further decrease the cost of capital of the firm which will increase the profit of the company. but in the reverse case as in the reverse scenario the financial institution will not provide low rate loan to the firm because of the recession of the market, therefore, the best case is to raise a loan from the owners capital(DUSHI). For Example, if the market is showing the high demand for funds in the industry and high return from particular industry than the financial institutions will be eagerly willing to lend money to such companies that are operating in that particular industry. The financial institution that will provide finance at the comparatively lower rate. But if any industry is suffering from the time of recession than a financial institution will have to take is a risk by investing funds in that industry. If the risk is big than the financial institution will demand a high return on the investment, which will increase the cost of capital of companies operating in such industries. Existing capital structure of the company: the Existing capital structure of the company is also very important if the company is planning to raise investment. The current capital structure will be examined properly by the experts and the change in the market condition to stabilize the risk associated with the cost of capital. For Example, if the current Debt and Equity ratio is .30 and it wants to decrease the debt and equity ratio of the company because this Debt and Equity Ratio is too risky in the current market conditions than the management of the company should plan to raise the funds through issue of new equity shares. This will increase the equity capital of the company and then the debt-equity ratio will get automatically decrease fulfilling the requirement of the management decision. If the management of the company has directed to increase the Debt Equity Ratio by .05 than more debentures should be issued or long-term loan should be raised from the financial institutions( Kumar, 2013). Unsystematic risk: The Unsystematic risk is a big factor that should not be ignored while deciding the capital structure of the firm. The unsystematic risk is comprised of two types of risks which are a business risk and financial risk. The unsystematic risk is directly affecting the cost of capital of the company. The business risk includes the risk associated with the decision that the management of the company takes while making the investment decision for the company. While the finance risk means the risk associated with the capital structure of the company. These both risks are mixed together to form the Unsystematic risk of the company(Bhattacharjee). For example, if the company is having higher unsystematic risk that the cost of the capital will be higher the cost of capital of the company can be decreased by decreasing the unsystematic risk of the company. The unsystematic risk can be decreased by the company by managing the investment and capital decision of the company. Understanding the above discussed factors with the help of real Example Some of the ASX listed companies that are considering the above factor while making capital structure decision. APN Outdoor Group Limited is one of the prominent advertisement company operating in Australia and New Zealand is considering the fact of raising finance on the basis of the past capital structure. APN Outdoor Group Limited : APN Outdoor Group Limited is an advertisement company and the capital structure of the company is decided by the management of the APN Outdoor Limited by considering the current Capital structure of the company. The capital structure of the company consisted of Debt Equity Ratio of .39 in the year 2014. This debt-equity ratio has decreased in the year 2015 to .288 because of a decrease in the long-term loan of the company. The company has decided to maintain the debt Equity ratio of the previous year which was .39. This can be done by increasing the long-term loan of the company or decrease the equity share capital of the company. In the year 2016 company has increased the long-term loan of the company to $103 million from$ 66 million. The Debt-Equity ratio of the company that got back to its past rate at .383. Year Equity Debt Debt Equity Ratio 2014 216 85 .39 2015 248 66 .266 2016 269 103 .383 Conclusion From the above case, the cost of capital and various important factors that will influence the capital structure decision are discussed. The report is presented after deep analysis of the journal articles that are available on the internet in this regard. From the above discussion, it is made clear that the cost of capital is the cost incurred by the company by obtaining outside finance for the extension and operation of business activities. The cost of capital should be minimized by the company and this can be only done by fixing a proper mix of the capital structure of the company. The capital structure should consist both outside and inside source of finance. More outside source of finance increases the risk of the company and enough sources are not available from inside sources of finance for the expansion of the company. The sources of finance should be analyzed by the management of the company and suitable source should be selected. Bibliography Bhattacharjee, D. (n.d.). Factors Affecting Cost of Capital. Retrieved September 28, 2017, from SCRIBD: https://www.scribd.com/doc/36913512/Factors-Affecting-Cost-of-Capital DUSHI, G. (n.d.). Factors that Determines the Cost of Capital. Retrieved September 28, 2017, from Preserve Articles: https://www.preservearticles.com/2014120333569/factors-that-determines-the-cost-of-capital.html Kumar, V. (2013). Factors Affecting Cost of Capital. Retrieved September 28, 2017, from Accounting Education: https://www.svtuition.org/2013/06/factors-affecting-cost-of-capital.html Nirajini, A. (2013). Impact of Capital Structure on Financial Performance of the Listed Trading Companies in Sri Lanka. Retrieved September 28, 2017, from International Journal of Scientific and Research Publications, Volume 3, Issue 5,: https://www.ijsrp.org/research-paper-0513/ijsrp-p1778.pdf S, N. (2016). The impact of capital structure on Financial Performance of the firms: Evidence From Borsa Istanbul. Retrieved September 28, 2017, from Journal of Business Financial Affairs: https://www.omicsonline.org/open-access/the-impact-of-capital-structure-on-financial-performance-of-the-firmsevidence-2167-0234-1000173.pdf Vatavu, S. (2105). The Impact of Capital Structure on Financial Performance in Romanian Listed Companies. Retrieved September 28, 2017, from Science Direct: https://www.sciencedirect.com/science/article/pii/S2212567115015087