Factors Affecting the Cost of Capital Quiz

10 Questions

Which of the following factors affects the cost of capital of a firm?

General economic conditions

What happens to the cost of capital when there is inflation?

It increases

What is the term used to describe the additional returns required by investors for purchasing securities with significant risk?

Risk premium

How do creditors respond when there is an increase in the demand for money without an equivalent increase in supply?

They raise their required rate of interest

What is the effect of an increase in risk on the required rate of return?

It increases

What are the factors that determine and affect the cost of capital of a firm?

The factors that determine and affect the cost of capital of a firm are general economic conditions and market conditions.

Explain how general economic conditions affect the cost of capital.

General economic conditions determine the demand for and supply of capital within the economy as well as the level of expected inflation. An increase in the demand for money without an equivalent increase in supply leads to an increase in the required rate of interest, resulting in a change in the cost of capital. Inflation also leads to an increase in the cost of capital as investors require a higher rate of return to compensate for the loss in purchasing power of money.

What is the relationship between risk and the required rate of return?

As the risk associated with an investment increases, the investor requires a higher rate of return to compensate for the additional risk. This increase in required rate of return is called the risk premium.

Define 'risk premium' in the context of investing.

'Risk premium' refers to the additional returns or compensation required by investors for purchasing securities with significant risk. It is the difference between the expected rate of return on a risky investment and the risk-free rate of return.

How do market conditions affect the cost of capital?

Market conditions play a significant role in determining the cost of capital. When investors face a higher level of risk in the market, they will demand a higher rate of return to make the investment attractive. This increase in the required rate of return leads to an increase in the cost of capital.

Study Notes

Factors Affecting the Cost of Capital

General economic conditions determine the demand for and supply of capital in an economy.
If the demand for money increases without an increase in supply, creditors will raise their required rate of interest, leading to a change in the cost of capital.
Inflation leads to a deterioration in the purchasing power of money, causing investors to require a higher rate of return, thus increasing the cost of capital.
Market conditions play a role in determining the cost of capital.
When investors purchase securities with significant risk, they require additional returns to make the investment attractive.
As risk increases, investors demand a higher rate of return, known as the "risk premium."
The risk premium contributes to the overall cost of capital.
The cost of capital is affected by the interest rates set by creditors.
Changes in interest rates directly impact the cost of capital.
The cost of capital is influenced by the availability of credit.
If credit is readily available, the cost of capital may be lower.
Conversely, if credit is scarce, the cost of capital may be higher.