· What are main elements in calculating the cost of capital? How would an increase in debt affect it? How would you identify an organization's optimal cost of capital? Is the cost of capital increasing or decreasing for most companies?
Some main elements are the liquidity of a company's debt, and the maturity of the debt. If the debt would increase would be higher, the premium would be lower. Just as if the liquid debt is less, the premium would be higher. Well financially dealing with an organization we have to take everything into consideration from the company's debts to the company's assets and liabilities. Keeping an eye on the internal and external players as far as spending and money that is being taken in can say a lot about a company's financial future.
I see the main elements in calculating cost of capital as those that are done with the cost of debt and equity and preferred stock. This includes calculating cost of capital by reviewing investor's required rate of return, floatation costs and, if applicable, corporate taxes. In order to manage the debt and equity, financial policies must be adhered to, since they do have an effect on the cost of capital.
An increase cost of debt is an indication of a higher risk, which therefore can increase the required rate of return. This can then increase the cost of capital. Additional costs may be accrued with higher debt. Things like higher loans, higher interest payments, and any other costs that may be associated with the increased debt.
In identifying the optimal cost of capital for an organization calculations have to be made of all included factors. This will vary with the individual organization and their required costs, the market, and the balance between the factors - Cost of debt, equity and preferred stock. The weighted cost of capital needs to be reviewed by management of the organization. Options that increase the value of stockholder investment, keeping risk in a reasonable range, and factor in reasonable financing options can help determine an optimal situation.