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(^30) Financial Management
specific type of financing for a firm is somehow functionally related to the riskless cost
of that type of financing adjusted for the firmís business and financial risk
(i.e., that kj = f(r; b, f).
The reader should recognize that the riskless cost of each type of financing, ëI, may
differ considerably. In other words, at a given point in time the riskless cost of debt may
be 6 percent while the riskless cost of common stock may he 9 percent. The riskless
cost is expected to be different for each type of financing, j∑ The risk less cost of
different maturities of the same type of debt may differ, since longer-term Issues are
generally viewed as more risky.
Factors determining the cost of capital
There are several factors that impact the cost of capital of any company. This would
mean that the cost of capital of any two companies would not be equal. Rightly so as
these two companies would not carry the same risk.
l General economic conditions: These include the demand for and supply of
capital within the economy, and the level of expected inflation. These are reflected
in the riskless rate of return and is common to most of the companies.
l Market conditions: The security may not be readily marketable when the investor
wants to sell; or even if a continuous demand for the security does exist, the price
may vary significantly. This is company specific.
l A firm's operating and financing decisions: Risk also results from the decisions
made within the company. This risk is generally divided into two classes:
n Business risk is the variability in returns on assets and is affected by the
company's investment decisions.
n Financial risk is the increased variability in returns to the common stockholders
as a result of using debt and preferred stock.
l Amount of financing required: The last factor determining the company's cost
of funds is the amount of financing required, where the cost of capital increases
as the financing requirements become larger. This increase may be attributable to
one of the two factors:
n As increasingly larger public issues are increasingly floated in the market,
additional flotation costs (costs of issuing the security) and underpricing will
affect the percentage cost of the funds to the firm.
n As management approaches the market for large amounts of capital relative
to the firm's size, the investors' required rate of return may rise. Suppliers of
capital become hesitant to grant relatively large amounts of funds
without evidence of management's capability to absorb this capital into the
business.
Generally, as the level of risk rises, a larger risk premium must be earned to satisfy
company's investors. This, when added to the risk-free rate, equals the firm's cost of
capital.