Cost of capital is the cost for a business but return for an investor. There are various factors that can affect the cost of capital. Broadly, factors can be classified as ‘fundamental factors’ and ‘economic and other factors’. Fundamental factors are market opportunities, capital provider’s preference, risk, and inflation. Other factors include Federal Reserve policy, federal surplus and deficit, trade activity, foreign trade surpluses and deficits, country risk and exchange rate risk.
Table of Contents
- 1 Fundamental Factors affecting Cost of Capital
- 2 Economic and Other Factors Affecting Cost of Capital
- 3 Individual Company Factors Affecting Cost of Capital
Fundamental Factors affecting Cost of Capital
Unquestionably, most fundamental price deciding factor for anything in this world is the law of demand-supply. Cost of capital is also not away from this fundamental law. When the demand for capital increases, the cost of capital also increases and vice versa. The demand is influenced greatly by the available market opportunities. If there are a lot of production opportunities in the market, more and more entrepreneurs will explore those opportunities to create profitable ventures. Entrepreneurs, then, would require capital to implement their business ideas. So, cost of capital is directly related to the market opportunities available in the market.
Capital Provider’s Preferences
An individual who has some additional funds has two straight choices – save money or consume it. It is completely a personal choice but to a great extent, it is impacted by the culture of a society. For example, Japanese people are more bent towards saving compared to the US. Another important factor that determines the utility of capital is the interest rate or returns available to their funds. Naturally higher returns would enforce higher savings.
‘High-risk high-return’ principle works here too. If the venture where investment is required has a high level of risk, the return required by the investor would also be very high to compensate the risk. On the other hand, the businessman taking up the venture may not opt for a too high cost of capital because it may put the viability of the overall project at stake. So, this is how risk plays a key role deciding the capital transactions in the market.
All capital providers try to invest in a manner that maximizes returns. The lower benchmark for investing has always been the inflation. At the minimum, an investment should beat the inflation and there should be some real income. Real income is nothing but the actual return less inflation. In simple words, you invested money which could buy you a particular basket of things a year ago. After a year when your investment is matured and you receive money, you would at least expect that money should be able to buy that same basket of things. If the matured money falls short of buying you the same basket, you have diminished the value of your money in last one year. If the money is more than just buying that basket, you have earned real income on your investment.
Economic and Other Factors Affecting Cost of Capital
Federal Reserve Policy
All federal banks have got the power to influence the economy. US Federal Reserve Board simple purchases the treasury securities, normally held by banks, to boost the economy. Let’s understand how it works. When the ‘Federal Reserve Board’ buys the Treasury securities from the banks, the banks accumulate a lot of loanable funds with it. Now, the banks with a higher supply of funds would start offering loans at lower interest rates. This reduction in interest rates will encourage industrialists to start more and more ventures and that, in turn, will create job opportunities, overall demand in the market etc. Although, there is a flip side of this policy that it will increase the inflation in the longer run. This is how federal policies have a great impact on the cost of capital.
Federal Budget Deficit or Surplus
Federal budget deficit and surplus also have a role to play in deciding the cost of capital in the market. In a surplus situation, Fed would buy Treasury securities from the market and that will reduce the interest rates. On the contrary, in a deficit situation, Fed would sell Treasury securities or mint money. Minting money would increase the money supply in the market along with an expectation of higher inflation and that leads to increasing the cost of money. Similarly, selling Treasury securities to banks will reduce the loanable funds with banks and they increase the cost of funds.
Economic boom and recession also play a very important role in determining the cost of capital by impacting the interest rates in the market.
Foreign Trade Surpluses or Deficits
A foreign trade deficit creates a need for borrowing from other countries. Borrower countries will have their own opportunity cost of capital based on the interest rates available with other countries. Higher the borrowings and higher will be the interest rates. That will impact the capital market.
Country risk is the risk associated with political, social, economic environment of a country. To understand with an example, assume a country has trends of suddenly changing the tax rates, regulations relating to trade and commerce etc. An international investor would resist investing in that country because their policy can put any business at stake suddenly. This will reduce the flow of international capital in the country and thereby increase the cost of capital.
Exchange Rate Risk
Investment in countries other than the home country has a bearing of exchange rate risk on them. The real return of an investor depends on two factors.
- The performance of the investment in the foreign country and
- The performance of the currency of that country in comparison to home currency.
At the time of maturity of the investment, if the home currency weakens, the net realization in home currency would also be reduced. That can affect an investor’s decision of investing in other countries, especially whose currency rates fluctuate a lot.
Individual Company Factors Affecting Cost of Capital
Capital Structure Policy
All companies try to optimize their capital structure with a policy that suits their individual situations. New acquisition of capital will depend a lot on the capital structure policy and therefore the capital structure policy of the said company will have a bearing on its cost of capital.
A dividend policy of a corporation decides how much percentage of profits it will retain and how much will be distributed as dividends. If a company retains higher percentage of profits in the business, it is effectively adding a capital at the cost of equity. Accordingly, the overall cost of capital will be impacted.
A company is nothing but a set of different projects it takes up. It is very important to note that different projects would have different risk profile. If a company is adding a project with higher risk compared to overall risk level of the organization, it is effectively increasing the risk of the organization. With this increase in risk, the required rate of return will also increase. This is how, investment policy impacts the cost of capital1,2