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What are the main elements in calculating cost of capital? How would an increase in debt affect the cost of capital?

Essentially, the calculations 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, when applicable, corporate taxes. In order to manage said 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 in turn increases the cost of capital.  Additional costs may be accrued with higher debt, such as higher loans, higher interest payments, and any other costs that may be associated with the increased debt.

How would you identify the optimal cost of capital for an organization?

To identify the optimal cost of capital for an organization, calculations have to be made of all included factors. This will vary on the individual company and their required costs, the market, and the balance between the factors – Cost of debt, equity and preferred stock.  The weighted cost of capital should be reviewed by management. Options that increase the value of stockholder investment, keeping risk within reason, and factor in reasonable financing options can help determine an optimal situation.

 

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