Factors that Determines the Cost of Capital



Cost of capital is an important concept in financial management. Various financing and investing deci­sions depend upon the cost of capital of a firm. There are several factors that make cost of capital of a firm high or low.

Some of the important factors are discussed below:

1. Demand and Supply of Capital:

Demand and supply of capital affects the cost of capital. If the demand for funds in the economy increases, lenders will automatically increase the required rate of return and vice-versa. Supply of funds has an inverse relation to cost of capital: If supply of fund increases then the cost of capital decreases; and if the supply of funds decreases, the cost of capital increases.

2. Market Condition:

The market condition of the product produced by the project for which a fund is required is an important factor for determining the cost of capital. Funds required for risky projects increases the cost of capital, as lenders demand a higher rate to compensate their risk. On the other hand, if the market condition of the products produced by the project is such that it will have a high and secured return, then the risk will be lower and obviously the cost of capital will be less.

3. Unsystematic Risk:

Unsystematic risk is of two types: Business risk and financial risk. Business risk arises due to investment decisions of the company. Financing risk arises due to financing decisions, i.e. proportion of debt and equity in the capital structure. Business risk and financing risk affect the overall cost of capital of a firm. A firm's total unsystematic risk is the sum of business and financing risks. The cost of capital is directly proportional to the total unsystematic risk of the firm.

4. Volume of Financing:

Volume of financing also affects the cost of capital. High volume of capital also increases the overall cost of capital due to issue related costs and the greater risks involved. The liquidity risk associated with high volume of capital also increases cost of capital. If the firm uses lower volume of capital then the suppliers of the fund remain more assured of their fund and the cost of capital reduces.