Question

Explain the following statement:

"The cost of capital curve is U-shaped."

Support your explanation. Be specific. What are the implications of this statement for the financial manager? How is risk and risk tolerance related to the cost of capital curve?

Answer 1

U shaped curve:

The curve is said to be U shaped, this is because the variable cost per unit of output will decrease as output increases. After the low, the variable cost per unit of output starts to increase. The increase in average variable costs is indirectly related to law of diminishing marginal returns.

Thus we can say that if each unit of variable factor costs the same, but output from additional unists increase, the firm obtains increasing output for every additional expense. In other words the company would like to produce optimum quantity because of lower average cost. On the other hand, if demand fluctuates,, then the company would alter its scale of production.

Implications on financial manager:

The curve provides an indication to the manager. After the leverage level is associated to high cost, a higher fraction of EBITDA is required to pay the service debt in which case the debt level starts to fall. In other words, there is threshold on cost of debt that maximizes the leverage level of firms as a result of which leverage falls.

The result is that firms paying higher service on their debts are likely to face financial distress. So debts levels are expected to fall to the margin as the cost of debt service increases.

Risk & risk tolerance:

Low levels of uncertainty are associated with low potential returns &high uncertainty with higher returns. The risk return trade off says that invested money can earn higher profits if the investor is ready to accept possibility of losses.

Risk tolerance on the other hand is the degree of variability from the investment returns that the investor would be ready to face. If the investor takes too many risks he might panic & sell at the wrong time.