## Factors Affecting Cost of Capital and Choice of Weights

### Factors Affecting Cost of Capital

Factor	Effect on Cost of Capital
Supply and Demand	High demand (boom) → higher cost; excess supply → lower cost
Investor Preferences	Cultural savings habits affect capital pool; higher returns attract more savings
Risk and Return	Higher perceived risk → investors demand higher return → higher cost
Inflation	Investors seek returns above inflation; higher inflation → higher cost of capital
Exchange Rates	For multinationals: currency fluctuation risk adds to capital cost

> Core logic: Cost of capital = Risk-free rate + Risk premium. Anything that increases risk or reduces the capital supply increases cost.

### Choice of Weights: Book Value vs Market Value

When calculating WACC (Weighted Average Cost of Capital), weights can be assigned based on either Book Value (BV) or Market Value (MV).

Point of Comparison	Book Value (BV)	Market Value (MV)
Definition	Based on historical cost (Balance Sheet values)	Based on current market prices of equity and debt
Reflects Current Conditions	May NOT reflect current economic value	Accurately reflects present market conditions
Stability	More stable (no daily fluctuations)	Volatile — affected by market movements
Relevance for Investors	Less relevant — ignores market perceptions	More relevant — reflects investor sentiment
Ease of Calculation	Easier — data from balance sheet	More complex — needs current market data

### Which Should Be Used?

Academically preferred: Market Value weights — they better represent the true cost to the firm at current prices.
Practically used: Book Value weights — more stable, readily available, and less subject to manipulation.
Exam answer: Both have merit; market value is theoretically superior but book value is more practical.

Worked example

### Example 1

Q: A company has the following capital structure:

Equity: Book Value ₹5,00,000 | Market Value ₹8,00,000
Debt: Book Value ₹5,00,000 | Market Value ₹4,50,000

Calculate weights using (a) Book Value and (b) Market Value.

(a) Book Value Weights:

Total BV = ₹5,00,000 + ₹5,00,000 = ₹10,00,000
Equity weight = 5/10 = 50%
Debt weight = 5/10 = 50%

(b) Market Value Weights:

Total MV = ₹8,00,000 + ₹4,50,000 = ₹12,50,000
Equity weight = 8/12.5 = 64%
Debt weight = 4.5/12.5 = 36%

Note: Market value weights reflect that equity has appreciated while debt trades at a slight discount, giving a different (and more current) picture of the financing mix.

### Example 2

Q: How does inflation affect the cost of capital? Give an example.

A: Inflation erodes the purchasing power of future returns. Investors demand a higher nominal return to maintain real returns.

Example: If real return expected = 8% and inflation = 5%, investors demand approximately 13% nominal return (Fisher Effect: approximately real rate + inflation).

This means the company must offer higher returns to attract capital → cost of capital increases with inflation.

⚠️ Common exam mistakes

Stating that book value is always better than market value – neither is universally superior; MV is theoretically preferred, BV is practically preferred.
Forgetting exchange rate risk as a factor – relevant for multinational companies raising capital in foreign currencies.
Not linking 'supply and demand' to booms/recessions – in economic booms, demand for capital rises (many investment opportunities) which pushes up cost of capital.
Mixing up WACC weights calculation: always use proportions (each component ÷ total), not absolute amounts.

Reference:

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Factors Affecting Cost of Capital and Book Value vs Market Value Weights

Worked example

⚠️ Common exam mistakes