Factors Affecting the Cost of Capital

CFA Level 1 - Corporate Finance

These are the factors affecting cost of capital that the company has control over:

Capital-structure policy

Dividend policy

Investment policy

Capital Structure Policy

As we have been discussing above, a firm has control over its capital structure, targeting an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.

Dividend Policy

Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule can be changed. For example, as the payout ratio of the company increases the breakpoint between lower-cost internally generated equity and newly issued equity is lowered.

Investment Policy

It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.

Uncontrollable Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company has no control over:

Level of interest rates

Tax rates

Level of Interest Rates

The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital.

Tax Rates

Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.

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