Determine The key factor affecting financing Costs

Because cost of capital is measured under the assumption that both firm's asset structure and its capital (financial) structure are fixed, the only factor which affects various specific costs of financing is the supply and demand forces operating in the market for long-term funds. Or we can say that as a firm raises long-term funds at different points in time, the only factor affecting their cost is riskless cost of the particular type of financing. Regardless of the kind of financing used, the below relationship should prevail:

kj = rj + b + f

Where

kj = the specific cost of the various types of long-term financing,

rj = the riskless cost of the given type of financing, j

b = the business risk premium

f = the financial risk premium

Equation indicates that cost of each specific type of capital depends on riskless cost of that type of funds, business risk of the firm and financial risk of the firm.