Firms have to be transparent and carefully scout both domestic and international markets, says Ajay Shah
Financial markets give capital to different borrowers at different prices. This is obviously evident in debt, where a bond issued by firm A may offer a return of 20 per cent while a bond issued by firm B could run at 11 per cent. The cost of equity capital is also sharply different across firms. The simplest way to see this is to compare P/E ratios. A firm with a P/E of 100 is getting capital at a much lower price than a firm with a P/E of 10.
Why is the cost of capital different across firms? One key factor, obviously, is risk. A riskier project will require a higher return, i.e. a risk premium. In addition, there is a liquidity premium. A more liquid security requires lower returns, in the eyes of an investor, than a less liquid security.
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Many aspects of risk premia and liquidity premia are determined in the economy as a whole. Sound macro-economic management reduces volatility of the equity index, which should reduce the equity premium in the long run. Improvements in financial infrastructure, such as the depository, reduce the cost of transacting, which yields higher security prices for all issuers. These issues are played out in the finance ministry, and not the firm.
What can a firm do to improve it