Why might the cost of capital fall if financial markets are no longer Essay

Why might the cost of capital fall if financial markets are no longer segmented What evidence is there of this effect - Essay Example Last two decades witnessed greater segmentation of financial markets. The major causes of increased financial market segmentation can be attributed to economic and regulatory barriers that raise difficulties in full market integration. 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. This paper will discuss why the cost of capital falls if financial markets are no longer segmented. Factors affecting cost of capital From a company’s point of view, the return on investment which is required to satisfy the investor’s interests is called cost of capital. Cost of capital consists of several factors such as equity capital, debt holders, and hybrid securities (Cost of capital). In order to understand the fluctuations in cost of capital associated with financial market segmentation, it is necessary to evaluate the factors affecting cost of capital. There are controllable and uncontrollable factors that affect cost of capital. A. Controllable factors As the term indicates, the company has a control over these factors and it is grouped into three such as capital structure policy, dividend policy, and investment policy. 1. Capital structure policy As discussed above, equity capital is a component of cost of capital. When more equity is issued, normally, cost of equity increases and thereby cost of capital. A similar process repeats when more debt is issued. 2. Dividend policy The dividend policy affects the cost of capital and it can be controlled by adjusting firm’s payout ratio. Since the firm has control over its payout ratio, MCC schedule’s breakpoint can also be effectively changed (CFA level 1- Factors affecting the cost of capit al). 3. 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 cost of capital also. B. Uncontrollable factors It also affects the cost of capital and the company has no control over these factors. It mainly includes level of interest rates and tax rates. In the view of Kapil (280), economic and market conditions also contribute to the change in cost of capital and these elements also fall under the head uncontrollable factors. 1. Level of interest rates â€Å"The level of interest rates will affect the cost of debt and, potentiality, the cost of equity (CFA level 1†¦..)†. For instance, level of interest rates has a direct impact on cost of debt by which an increase in interest rates causes a proportional increase in cost of debt and which in turn increases cost of capital. 2. Tax rates Cost of debt afte r taxation is clearly affected by changing tax rates. When tax rates increase, it is obvious that cost of debt would decrease further causing a decline in cost of capital. Lack of financial market segmentation and cost of capital fall 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 large number of local shares were included in these concentrated segments. The authors argue that this situation led to the rise in cost of capital. According to this argument, 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