Journal of Financial Economics

Financial
Economics

FINANCE
1
Question-Answers
Answer 1
There are various determinants of cost of capital such as current economic conditions,
getting of new fund, current capital structure, current income tax rates, current dividend policy
and the others. External and uncontrollable variables and unsystematic risk are the systematic
risk that can be control and known variables1.
Current Economic Conditions are the systematic risk which defines the bank interest rate
whether it is increases or decreases. If the company cost of debt has been decreases due to low
rate of bank interest. Low cost of capital directly affects the cost of capital in the positive terms.
There is high amount of expenses of interest which states that the company has high effect on
leverage on cost of capital.2
According to the Current dividend policy, the firm has to make dividend policy in terms of
total earning which is considered as the non-systematic risk. It relies on the company weather it
wants to issue the share or not on the specific rate. Current dividend policy states that the
company has less effect of leverage on cost of capital as it depend on the company to issue the
shares or not.
1 Key differences. Difference Between Systematic and Unsystematic Risk
2 Svtution. Factors Affecting Cost of Capital

FINANCE
2
Financial and Investment Decisions states that the company uses the shares or debt to raise the
capital. The company has to inform the investors about the usage of funds. If the investors found
risk then directly decreases the raising capital of the company. Financial and investment decision
has a systematic risk factor as the attracting the investors or informing them is necessary for the
company which is non-controllable expenses. The effect of leverage on cost of capital is high as
the company has to pay interest on liability and dividend on issuing of shares. 3
Answer 2:
Advantage and Disadvantage of debt
The advantage of debt to the company capital structure is its low financing cost. It is
observed that uses the debt as the source of fund takes the less amount of cost to borrow it which
affects the capital structure more effective. The other advantage of debt to the company is to
maximize the effect of financial leverages. The company uses the debt as the source of fund then
the equity holders get the dividend after deducting the interest expenses due to which the cost of
capital is reduced and the effect of leverage is also reduces. The amount of tax is also decreases
due to high amount of liabilities.4
The disadvantage of debt as the source of fund is the collateral terms. It is essential for
the company to provide collateral to the lender in exchange of borrowing money. The company
can give business assets at the potential risk which means it gives assets as the guarantee of loan
If the company able to gives the return amount of lending money then it can easily takes its
3 Robinson, International financial statement analysis.
4 Schroeder, Myrtle,, and Jack. Financial accounting theory and analysis.