What factors should you consider when determining the cost of capital for your business?

2 Market conditions

Another factor that influences the cost of capital is the market conditions, such as the interest rates, the inflation rates, the exchange rates, and the economic cycles. These factors affect the availability and cost of financing from different sources, as well as the expectations and preferences of investors and lenders. For example, when the interest rates are low, debt financing becomes cheaper and more attractive, while equity financing becomes more expensive and less appealing. Similarly, when the inflation rates are high, the real value of future cash flows decreases, and the cost of capital increases.

3 Financing sources and mix

The cost of capital also depends on the financing sources and mix that you use for your business or project. There are three main sources of financing: equity, debt, and retained earnings. Each source has its own advantages and disadvantages, and its own cost. Equity is the most expensive source of financing, as it requires giving up ownership and control of your business, and paying dividends to shareholders. Debt is cheaper than equity, as it provides a tax shield and does not dilute ownership, but it also increases the financial risk and the obligation to pay interest and principal. Retained earnings are the cheapest source of financing, as they are the profits that you reinvest in your business, but they also limit the growth potential and the payout to shareholders. The optimal mix of financing sources depends on your business goals, risk profile, and capital structure.

4 Tax implications

The last factor that you should consider when determining the cost of capital is the tax implications of your financing decisions. Taxes affect the cost of capital in two ways: by reducing the after-tax cash flows of your business or project, and by altering the relative cost of different financing sources. For example, interest payments on debt are tax-deductible, which lowers the effective cost of debt, while dividends on equity are not, which increases the effective cost of equity. Therefore, you should always use the after-tax cost of capital when evaluating your investments or projects, and take into account the tax benefits and costs of your financing sources.

5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?