Why do different sources of finance have different costs?

CPA-Financial-Management-Section-3 Revision kit

Why different sources of capital have different costs. Different sources have different costs because of:
– Duration of lending e.g. long term loans will earn a higher interest rate than short term loans due to the maturity risk premium.
– Size of loan – usually, large borrowers will be charged higher interest rates than their small borrowers.
– Uncertainty of returns e.g interest charges are fixed hence lower cost of debt compared to dividends which are uncertain thus higher cost of equity.
– Different types of financial assets some borrowers e.g building societies will offer higher yields to depositors to attract them. Their bonds have high interest rate.
– Perceived risk by lenders:
– Borrowers who are perceived by different market segments to be high risk will have to incur higher cost of capital.
– Need to make profit margin:
– Depending on the source of funds for lending, different sources of capital will add a % profit margin thus different cost of capital.

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