Question

The Finance Manager of Plaggio Ltd. believes that the cost of capital of a firm influences firm value and that it is very much related to the capital structure policy of a firm. The capital structure of a firm consists of debt and equity. To determine the cost of capital of the firm, he has collected the following information:
i) The firm‟s capital structure comprises of 30 per cent debt and 70 per cent equity.
ii) The firm has bonds outstanding with 20 years to maturity; 12 per cent annual
coupon rate; face value of RM1,000; and the current bond price is RM1,252
iii) The firm uses Capital Asset Pricing Model (CAPM) to compute the cost of equity with the risk free rate at 2.5 per cent per annum, stock beta of 1.6 and market return of 12% per annum.
iv) The firm pays tax at a rate of 30 per cent.
Required:
(a) Explain any TWO (2) factors that are generally beyond a firm’s control that could affect the firm’s cost of capital.

Answer 1

There are whole lot of factors which are outside a company's control and affects it's capital structure.

1. Inflation: Inflation tends to play a major role in determining interest rates which affects the cost of capital of firm. In the period of high inflation value of debt reduces while cost of debt shoots up, equity value tends to depress in the time of high inflation. Both of these factors when combined tends to have negative effect of cost of capital.

2. Country risk: There is a high risk of political, social, and economic environment of a country. Due to high levels of uncertainity risk premiums relating to this factor increases which will have a negative effect on company's cost of capital.

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