Factors That Affect the Weighted Average Cost of Capital
by MaestroThe cost of capital is affected by a number of factors. Some are beyond the firm’s control,but others are influenced by its financing and investment policies.
Factors the Firm Cannot Control
The three most important factors that are beyond a firm’s direct control are (1) the level of interest rates, (2) the market risk premium, and (3) tax rates. The Level of Interest Rates If interest rates in the economy rise, the cost of debt increases because firms will have to pay bondholders a higher interest rate to obtain debt capital. Also, recall from our discussion of the CAPM that higher interest rates also increase the costs of common and preferred equity. During the 1990s, interest rates in the United States declined significantly. This reduced the cost of both debt and equity capital for all firms, which encouraged additional investment. Lower interest rates also enabled U.S. firms to compete more effectively with German and Japanese firms, which in the past had enjoyed relatively low costs of capital. Market Risk Premium The perceived risk inherent in stocks, along with investors’ aversion to risk, determine the market risk premium. Individual firms have no control over this factor, but it affects the cost of equity and, through a substitution effect, the cost of debt, and thus the WACC.
Tax Rates Tax rates, which are largely beyond the control of an individual firm (although firms do lobby for more favorable tax treatment), have an important effect on the cost of capital. Tax rates are used in the calculation of the cost of debt as used in the WACC, and there are other less obvious ways in which tax policy affects the cost of capital. For example, lowering the capital gains tax rate relative to the rate on ordinary income would make stocks more attractive, which would reduce the cost of equity relative to that of debt. That would, as we will see in Chapter 13, lead to a change in a firm’s optimal capital structure toward less debt and more equity.
Taken From : Credit Repair by Attorneys Robin Leonard and Deanne Loonin
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