Page 119 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes (b) Dividend Policy: The required capital may be raised by equity or debt or both. Equity
capital can be raised by issue of new equity shares or through retained earnings.
Sometimes companies may prefer to raise equity capital by retention of earnings,
due to issue of new equity shares, which are expensive (they involve flotation costs).
Firms may feel that retained earnings is less costly when compared to issue of new
equity. But if it is different it is more costly, since the retained earnings is income
that is not paid as dividends hence, investors expect more return and so it affects the
cost of capital.
(c) Investment Policy: While estimating the initial cost of capital, generally we use the
starting point as the required rate of return on the firm’s existing stock and bonds.
Therefore, we implicitly assume that new capital will be invested in assets of the
same type and with the same degree of risk. But it is not correct as no firm invest in
assets similar to the ones that currently operate, when a firm changes its investment
policy. For example, investment in diversified business.
2. Uncontrollable Factors: The factors that are not possible to be controlled by the firm and
mostly affects the cost of capital. These factors are known as External factors.
(a) Tax Rates: Tax rates are beyond the control of a firm. They have an important effect
on the overall cost of the capital. Computation of debt involves consideration of tax.
In addition, lowering capital gains tax rate relative to the rate on ordinary income
makes stocks more attractive and reduces cost of equity and lower the overall cost of
capital.
(b) Level of Interest Rates: Cost of debt is interest rate. If interest rates increases,
automatically cost of debt also increases. On the other hand, if interest rates are low
then the cost of debt is less. The reduced cost of debt decreases WACC and this will
encourage an additional investment.
(c) Market Risk Premium: Market risk premium is determined by the risk in investing
proposed stock and the investor’s aversion to risk. Market risk is out of control risk,
i.e., firms have no control on this factor.
The above are the important factors that affect the cost of capital.

Task Weighted average of cost of capital may be determined using book value and
market value weights. Compare the pros and cons of using market value weights rather
than book value weights in calculating WACC.

Self Assessment

Fill in the blanks:
13. The weighted average cost of new or incremental, capital is known as the ………………. .
14. Book value weights are based on the values found on the ……………….. .
15. The ……………….. cost of capital lies between the least and most expensive funds.

114 LOVELY PROFESSIONAL UNIVERSITY