Are the Cost of Capital Falls if Financial Markets are no Longer Segmented - Essay Example

Download file to see previous pages In the opinion of Buch (179), although direct regulatory restrictions such as capital controls to financial market integration have been eradicated, some complex forms of indirect regulatory controls are still in force. When the financial markets are largely concentrated, it will certainly increase the costs associated with international financial transactions.
From a company’s point of view, the return on investment which is required to satisfy the investor’s interests is called the cost of capital. The cost of capital consists of several factors such as equity capital, debt holders, and hybrid securities (Cost of capital). To understand the fluctuations in the cost of capital associated with financial market segmentation, it is necessary to evaluate the factors affecting the cost of capital. There are controllable and uncontrollable factors that affect the cost of capital.
Controllable factors. As the term indicates, the company has control over these factors and it is grouped into three such as capital structure policy, dividend policy, and investment policy.
Capital structure policy.  As discussed above, equity capital is a component of the cost of capital. When more equity is issued, normally, the cost of equity increases and thereby the cost of capital. A similar process repeats when more debt is issued.
Dividend policy. The dividend policy affects the cost of capital and it can be controlled by adjusting the firm’s payout ratio. Since the firm has control over its payout ratio, the MCC schedule’s breakpoint can also be effectively changed (CFA level 1- Factors affecting the cost of capital).
Investment policy. When a company formulates investment decisions, it deals with some degree of risk and it causes to change the structure of cost of debt and cost of equity. Consequently, it produces a proportional change in the cost of capital also.
Uncontrollable factors. It also affects the cost of capital and the company has no control over these factors. It mainly includes the level of interest rates and tax rates. In the view of Kapil (280), economic and market conditions also contribute to the change in the cost of capital and these elements also fall under the head uncontrollable factors.
Level of interest rates. “The level of interest rates will affect the cost of debt and, potentiality, the cost of equity (CFA level 1…..)”. For instance, the level of interest rates has a direct impact on the cost of debt by which an increase in interest rates causes a proportional increase in the cost of debt and which in turn increases the cost of capital.
Tax rates. The cost of debt after taxation is affected by changing tax rates. When tax rates increase, it is obvious that the cost of debt would decrease further causing a decline in the cost of capital.
When national financial markets are largely segmented, it becomes small and inactive. According to Errunza and Miller, as a result of this increased capital market segmentation, most of the domestic investors holding a large number of local shares were included in these concentrated segments. The authors argue that this situation led to the rise in the cost of capital. According to this argument, the cost of capital falls if financial markets are no longer segmented. In the opinion of Buchanan (as cited in The trade news), if the capital market traders have good knowledge regarding the trade of stocks, it would greatly increase the risk of market impact in the segmented market and thereby the cost of capital. In contrast, if the financial markets are not segmented, it would minimize the risk of market impact and causes a fall in the cost of capital. Strydom (64) reflects that increased financial market segmentation creates unfavorable economic conditions as segmented markets fail to meet the economic interests of investors. This situation largely affects the operating profit of the firms. ...Download file to see next pages Read More