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What is the Cost of Capital?

The Cost of Capital is known as the cost of financing for a business. It is the rate at which the business can obtain capital to grow its operations and maintain its business stable. The cost of capital is usually divided into the cost of equity (through the issuing of common stock) and the cost of debt (through issuing bonds, preference shares or taking out a loan). The overall source of the cost of capital for a firm is known as its weighted cost of capital. The firm’s overall cost of capital is extremely important as its operations must be able to generate returns that exceed the firm’s cost of capital in order to be profitable.

Factors which influence a firm’s ‘Cost of Capital’

There are a number of important factors which impact the cost at which a firm will be able to obtain funding to grow its business. These include:

  • The firm’s credit rating: This is a credit rating provided by firms such as Moody’s & Fitch which provides an objective evaluation of the company’s ability to repay debt. Businesses which have a good credit rating will certainly have a lower cost of capital than those which have a bad credit rating.
  • Profitability ratios: Firms which have a robust operating margin, low levels of debt and a high-interest coverage ratio, will generally have a cost of capital significantly below firms which have tighter margins and a high level of debt. This is because they are considered to be less risky to creditors and have more flexibility to meet their repayments even if the business experiences a slight downturn.
  • firm’s operating history: Businesses which have long histories and have been profitable for longer periods of time generally have lower costs of capital than recently established firms. A proven track record of success gives lenders confidence.
  • Nature of the business: Firms which are stable rather than cyclical are generally able to obtain a lower cost of capital. This is because their operations are not seasonal or subject to regular fluctuations.

Conclusion

A firm’s cost of capital is extremely important as it will impact profitability levels. Additionally, businesses which have a low cost of capital usually experience favourable operating conditions which allow them to grow the business.

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