Cost Of Finance
This is the price the company pays to obtain and retain finance. To obtain finance a company will pay implicit costs which are commonly known as floatation costs. These include: Underwriting commission, Brokerage costs, cost of printing a prospectus, Commission costs, legal fees, audit costs, cost of printing share certificates, advertising costs etc. For debts there are legal fees, valuation costs (i. e. security, audit fees, Bankers commission etc. ) such costs are knocked off from:
Cost of retaining finance includes dividends for share capital and interest for debt finance which is tax deductible. However, when computing the cost of finance apart from deducting implicit costs, explicit costs are the most central elements of cost of finance. The cost of capital is important because of its application in the following areas: i) Long-term investment decisions – In capital budgeting decisions, using NPV method, the cost of capital is used to discount the cash flows. Under IRR method the cost of capital is compared with IRR to determine whether to accept or reject a project.
ii) Capital structure decisions – The composition/mix of various components of capital is determined by the cost of each capital component. iii) Evaluation of performance of management –
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v) Lease or buy decisions – A firm may finance the acquisition of an asset through leasing or borrowing long-term debt to buy an asset. In lease or buy decisions, the cost of debt (interest rate on loan borrowed) is used as the discounting rate. Factors That Influence the Cost of Finance 1. Terms of reference – if short term, the cost is usually low and vice versa. 2. Economic conditions prevailing – If a company is operating under inflationary conditions, such a company will pay high costs in so far as inflationary effect of finance will be passed onto the company. 3.
Risk exposed to venture – if a company is operating under high risk conditions, such a company will pay high costs to induce lenders to avail finance to it because the element of risk will be added on the cost of finance which may compound it. 4. Size of the business – A small company will find it difficult to raise finance and as such will pay heavily in form of cost of finance to obtain debt from lenders. 5. Availability – Cost of finance prices will also be influenced by the forces of demand and supply such that low demand and low supply will lead to high cost of finance.
6. Effects of taxation – Debt finance is cheaper by the amount equal to tax on interest and this means that debt finance will entail a saving in cost of finance equivalent to tax on interest. 7. Nature of security – If security given depreciates fast, then this will compound implicit costs (costs of maintaining that security). 8. Company’s growth stage – Young companies usually pay less dividends in which case the cost of this finance will be relatively cheaper at the earlier stages of the company’s development. Term Structure of Interest Rates
The term structure of interest rate describes the relationship between interest rates and the term to maturity and the differences between short term and long term interest rates. The relationship between short and long interest rates is important to corporate managers because: 1. They must decide whether to buy long term or short term bonds and whether to borrow by issuing long-term or short-term bonds. 2. It enables them to understand how long term and short term rates are related and what causes the shift in their relative positions.
Several theories had been advanced to explain the nature of yield curve – These are: 1. Liquidity preference theory 2. Expectation theory 3. Market segmentation theory Liquidity Preference Theory This theory states that short term bonds are more favourable than long term bonds for 2 reasons. i) Investors generally prefer short term bonds to long-term securities because such securities are more liquid in the sense that they can be converted to cash with little danger of loss of principal. Therefore – investors will accept lower yields on short term securities.
ii) At the same time borrowers react in exactly the opposite way. Generally borrowers prefer long term debt because short-term debt exposes them to the risk of having to repay the debt under adverse. Conditions, accordingly borrowers are willing to pay higher rate other things held constant for long-term process than short ones. Taking together this two sets of preferences implies that under normal conditions, a positive maturity risk premium exist which increases with maturity thus the yield curve should be upward sloping.
Lenders prefer liquidity (short term hands) while borrowers prefer long term bonds and are willing to pay a “premium” for long term borrowing. Expectation Theory This theory states that the yield curve depends on the expectation about future inflation rates. If inflation rate is expected to increase, then the rate on long-term bonds will exceed that of short-term loan. The expected future interest rates are equal to forward rates computed from the expectations with regard to future interest rates are. Other factors which affect the expectations with regard to future interest rates are:
1) Political stability 2) Monetary policy of the government 3) Fiscal policy of the government (government expedition) 4) Social factors. The following conditions are necessary for the expectation theory to hold. i) Perfect capital markets exists where there are many buyers and sellers of security with non having a significant influence on the interest rates. ii) Investors have homogeneous expectations about future interest rates and returns on all investments. iii) Investors are rational wealth maximizers iv) Bankruptcy of firms due to use of borrowing is unlikely.
Market Segmentation Theory This theory states that the major investors (borrowers and lenders) are confined to a particular segment of the market and will not change even if the forecast of the likely future interest rates changes. The lenders and borrower thus have a preferred maturity. This implies that a person borrowing to buy a house or a company borrowing to build a power plant would want a long term loan while a retailer borrowing to build up stock in readiness for a peak reason would prefer a short term loan. Similar differences exist among savers.
Therefore a person saving to pay school fees for next semester would want to lend on in the short-term market. A person saving for retirement 20 years ahead would probably buy long-term security in long term market. The thrust of market segmentation theory is that the slope of yield curve depends on demand and supply mechanism. An upward sloping curve would occur if there was a large supply of funds relative to demand in the short term marketing but a relative shortage of funds in the long-term market would produce an upward sloping curve.