Question

Part 1:

The cost of capital is affected by some factors that are under the firm’s control and some that are not. What are the factors the firm can and cannot control and what will be the impact of these factors on company's average cost of capital (WACC)?

Part 2:

Use the Internet to research two (2) mutually exclusive investment projects to compare. The projects may involve any kind of investment, as long as the time frame for one (1) of the investments is a maximum of one (1) year (short term) and the time frame for the other investment is five (5) years minimum (long term). Be prepared to discuss this.

Answer 1

Cost of capital is the return expected by the providers of capital (share holders, lenders and the debt holders) to the business as a compensation for their contribution to the total capital.

The cost of capital is affected by some factors that are under the firm’s control and some that are not.

External Factors

• Capital providers preferences

Every individual have personal choices to decide how to use money, whether it is to be consumed or to be saved?. But to some extent culture of societies have impact on individuals decision.

• Inflation

At low inflation rates an increased rate of inflation would tend to increase capital cost,

• Trade Activity

  Economic boom and recession also play a very important role in determining the cost of capital by impacting the interest rates in the market.

• Risk

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.

• Political ,Social, Economic Conditions

Change in tax rate regulations, Change in NY other rules and regulations, current economic conditions etc.If there is big recession in the market, no financial institute will decrease the rate of interest because they also have to pay the return to their customers. It means, every loan providing company has also cost of capital. If there will be stability in the market, cost of debt will decrease and cost of equity capital will increase.

• Exchange Rate Risk

Exchange rate fluctuations effect performance of investment.

Internal Factors

• Current Capital Structure

Current debt equity ratio will effect the cost of capital. If debt is more than share capital, we have to pay more cost of debt. If share capital is more than debt, we have to pay cost of equity or pref. share capital..

• Current Dividend Policy

Dividend policy of a corporation decides how much percentage of profits it will retain and how much will be distributed as dividends. If Price earning ratio will increase, cost of retained earning will decrease because we will less money which have retained and use for promoting of business as source of fund.

• New Fund

Company's new fund's requirement will also affect the cost of capital. every time, when company will go to market for getting fund, company company will get the money at new market rate. So, company has also to follow new rate of cost of capital. It may increase or decrease company's current cost of capital rate.

• Financial and Investment Policy

Different projects would have different risk profile. If there is more risk in the investment, both shareholders and creditors will get high reward for this. So, our financial and investment decisions will effect the cost of capital.

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