Following are some of the factors which are relevant for the determination of cost of the firm.

The risk free interest rate, I_f , is the interest rate on the risk free and default-free securities. Theoretically speaking, the risk free interest rate, depends upon the supply and demand consideration in financial market for long term funds. The market sources of demand and supply determines the I_f , which is consisting of two components:

The real interest rate is the interest rate payable to the lender for supplying the funds or in other words, for surrendering the funds for a particular period.

Investors, in general, like to maintain their purchasing power and therefore, like to be compensated for the loss in purchasing power over the period of lending or supply of funds. So, over and above the real interest rate, the purchasing power risk premium is added to find out the risk free interest rate. Higher the expected rate of inflation, greater would be the purchasing power risk premium and consequently higher would be the risk free interest rate.

Another factor affecting the cost of capital is the risk associated with the firm’s promise to pay interest and dividends to its investors. The business risk is related to the response of the firm’s Earning Before Interest and Taxes, EBIT, to change in sales revenue. Every project has its effect on the business risk of the firm. If a firm accepts a proposal which is more risky than average present risk, the investors will probably raise the cost of funds so as to be compensated for the increased risk. This premium is added for the business risk compensation is also known as Business Risk Premium.

the financial risk is an another type of risk which can affect the cost of capital of the firm. The particular composition and mixing of different sources of finance, known as the financial plan or the capital structure, can affect the return available to the investors. The financial risk is often defined as the likelihood that the firm would not be able to meet its fixed financial charges. It is related to the response of the firm’s earning per share to a variation in EBIT. The financial risk is affected by the capital structure or the financial plan of the firm. Higher the proportion of fixed cost securities in the overall capital structure, greater would be the financial risk. The investor in such a case require to be compensated for this increased risk. They add financial premium over and above the business risk premium. It may be noted that the financial risk, like business risk, is also particular and related to the firm and is not affected by the external factors.

The investors may also like to add a premium with reference to other factors. One such factor may be the liquidity or marketability of the investment. Higher the liquidity available with an investment, lower would be the premium demanded by the investor. If the investment is not easily marketable, then the investors may add a premium for this also and consequently demand a higher rate of return.

In view of the above, the cost of capital may be defined as
     
                         k  = I_f + b + f

where    k =  Cost of capital of different sources.
                I_f = Risk free Interest rate
                b =  Business risk premium
                f  =  Financial risk premium

The equation indicates that the cost of capital of particular source of finance depends upon the risk free cost of capital of that type of funds, the business risk premium and the financial risk premium.  
           
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