cost of capital
Cost of capital for a company depends on many factors among which the following are essential:
- Managerial experience and competency
- Specific business risk
- Financial structure of the company
- Past cash flows, and their variability and consistency
However, for most financial institutions, the calculation of the cost of capital is quite complicated. For instance, a commercial bank is not pre-committed to a specific industry or business risk. The investor can discover the exact constituents of the asset risk profile only after the capital is deployed by the bank manager. (For instance, loans could all of a sudden be directed to the shipping industry.) Hence beliefs play a big role here. If the investor believes that the bank manager will deploy capital to high risk/high return sectors, then he will ask for a high interest rate. If bank manager believes that the cost of capital will be expensive, then he will be pre-disposed to employing the capital to a high risk/high return sector. In such a fashion, some Bayesian Nash equilibrium will sooner or later be reached.
Note that the following factors also complicate the cost of capital calculation for banks:
- Explicit government guarantees such as deposit guarantees
- Implicit government guarantees such as being regarded as too big to fail in a systemic crisis.
- Banks' exposure to each other can make it hard to pinpoint the business sectors that each bank is exposed to.
- Managerial experience and competency
- Specific business risk
- Financial structure of the company
- Past cash flows, and their variability and consistency
However, for most financial institutions, the calculation of the cost of capital is quite complicated. For instance, a commercial bank is not pre-committed to a specific industry or business risk. The investor can discover the exact constituents of the asset risk profile only after the capital is deployed by the bank manager. (For instance, loans could all of a sudden be directed to the shipping industry.) Hence beliefs play a big role here. If the investor believes that the bank manager will deploy capital to high risk/high return sectors, then he will ask for a high interest rate. If bank manager believes that the cost of capital will be expensive, then he will be pre-disposed to employing the capital to a high risk/high return sector. In such a fashion, some Bayesian Nash equilibrium will sooner or later be reached.
Note that the following factors also complicate the cost of capital calculation for banks:
- Explicit government guarantees such as deposit guarantees
- Implicit government guarantees such as being regarded as too big to fail in a systemic crisis.
- Banks' exposure to each other can make it hard to pinpoint the business sectors that each bank is exposed to.
