Cost of Finance – Meaning and Importance

The cost of finance refers to the price that a company pays to obtain financing for their business operations and assets. It is also called financing cost or cost of capital. Businesses and financial analysts use the cost of capital to determine if funds are being invested effectively. If the return on an investment is greater than the cost of capital, that investment will end up being a net benefit to the company’s balance sheets. To get finance, a company must incur implicit costs, which are often referred to as floatation costs.

Financing cost or cost of finance refers to the costs, interests and other charges involved in raising finance to purchase assets or run business operations. Costs of finance include underwriting commission, brokerage costs, cost of printing a prospectus, commission costs, legal fees, audit costs, and cost of printing certificate shares. There are also certain costs incurred when obtaining debt financing such as legal fees, valuation costs, banker’s commission, audit fees, etc.

The cost of finance is often influenced by security, credit rating, timing, and availability. Short term finances incur costs such as interest charge on loans. Banks often offer loans at fixed charges as interests, which are calculated as a percentage of the loan value. For example, a company that borrows KSH10 million at an interest rate of 10% will have to pay KSH1 million in addition to the principal amount. A bank overdraft also incurs annual maintenance fee on top of the interests charged. The interest charged on any type of short term loan varies based on the risk of default.

Interest is also the primary cost of a long term loan, which is lower if the loan is secured. Arrangement and maintenance fees, insurance, and transaction costs are also some of the costs associated with a long term loan. Equity finance also incurs costs such as flotation costs, which include the legal fees paid to financial advisers.

A company looking for listing in a stock market requires the services of a corporate adviser, stockbroker, corporate lawyer, accounting, and public relations firms. These advisers charge significant fees for the company, which is then considered to be part of the financing costs of the company. Further direct costs of listing are the admission and annual fees payable to the stock market. The admission fee is based on the market capitalisation of the company on the day of admission while the annual fee is fixed for all companies.

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