The Cost of Capital

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Cost of Capital

This paper examines key elements of a cost of capital policy to facilitate objective management and allocation of corporate funds. In order for a company to make long-term investments to grow, whether that is new equipment, new products or other assets, managers must be aware of the cost of acquiring any of these assets. The obvious objective for these managers is to earn more than the cost of capital and in doing so will increase their company’s market value. If they fail to adequately estimate their cost of capital and their long-term investments fall beneath the cost of capital, their company’s market value will decline as a result. This ongoing battle of managing and calculating the cost of capital and
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The greater predictability of the dividend policy normally signals a lower risk factor associated with the company which in turn lowers the overall WACC resulting in lower cost of capital. If the company is erratic on how they payout their dividends, they could face an adverse reaction to risk which would raise their WACC and cost on capital.
The last factor that is discussed under a controllable situation is investment policy. When company is consistent in their investment decisions, it is assumed that they are all relatively similar in degree of risk. However, when companies change their investment policy with either less or more risky investments the cost of debt and equity change accordingly. Managers need to take this into account when looking at the overall cost associated capital ensuring that the company is not paying more than what is necessary. Uncontrollable:
While managers can control some factors relating to the cost of capital the two more prominent factors that are uncontrollable are the levels of interest rates and the tax rates. When interest rates increase it affects the economy as a whole and increases the cost of debt, which increases the cost of capital. The tax rates on the other hand affect the after-tax cost of debt. As these rates increase, the cost of debt decreases and brings down the cost of capital. Managers are aware of

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