The cost of money is the price paid for utilizing money, whether borrowed or owned. In a nutshell, it is the rate of interest or dividend payment on borrowed money.
Every dollar spent by companies comes at a price. The cost of money is illustrated by the interest paid on loan capital and the dividends paid on ownership capital. The cost of money is affected by the supply and demand for capital. It varies with interest rate changes and is used to calculate the opportunity costs of investing that money in securities or other assets.
It is important to understand that firms face costs when raising capital. Companies need cash for their operations (e.g., to pay salaries, pay rent, and purchase raw materials) and to fund investment (e.g., building a new factory, developing a new product). If a company’s earnings are insufficient, they can obtain additional money via debt (meaning borrowing) or equity (shares of stock).
The required rate of return investors expect from equity capital is composed of compensation in the form of dividends and capital gains (stock price appreciation).
What Is The Required Rate Of Return And How Is It Tied To Risk? How Is It Used To Make Financial Decisions?
The required rate of return, also known as the hurdle rate or RRR, is the minimum return that an investor is expecting to receive for their investment. Essentially, the required rate is the minimum acceptable compensation for the investment’s level of risk.
The required rate is commonly used as a threshold that separates feasible and unfeasible investment opportunities. The general rule is that if an investments return is less than the required rate, the investment should be rejected. The RRR is a main driver of financial decisions, as a manager in a business is continually weighing the risk of undertaking an investment project against its anticipated return. So, for example, an investment project with a borderline investment return would be carefully evaluated against the risk profile of that project.
When one person lends something they own to someone else, the lender often asks for some compensation in return. This compensation, or payment, is called rent. Rent is what one person pays for the privilege of borrowing another person’s property.
Very often, people don’t borrow things—they borrow money to buy things. Borrowing money also has a rental price called interest. The rate of interest paid for borrowing money is expressed as a percent of the amount of money borrowed. For example, you may see an advertisement for car loans at 6.9%. This percent represents the interest rate, i.e., the cost to the consumer for borrowing the money needed to buy the car.
A Corporation’s Cost to Borrow
The cost to a corporation to borrow (the cost of debt or k) is determined by market forces and several other factors. Simply stated:
Quoted interest rate=k=krf+DRP+LP+MRP
The definitions are:
|k||k= The cost of debt to a company |
The cost of debt (k) to a company is the nominal interest rate a company must pay for its debt (loans from banks or bonds). Nominal means the rate includes an addition of expected inflation.
|krf||krf= The nominal risk-free rate |
No rates are entirely free of risk, but the closest thing in the real world are U.S. Government T-Bills— backed by the full faith and taxing authority of the U.S. Government. Normally, the U.S. Treasury 30-day T-Bill rate is used (quoted in most major newspapers) to define the [?]nominal risk-free rate (Krf)[/?]. As a nominal rate, krf includes the average expected inflation rate.
|DRP = Default Risk Premium||DRP=Default Risk Premium|
Default Risk Premium (DRP) is the risk that a company will not pay back the loan or debt obligation (bond). Many factors contribute to this (e.g., company size, business prospects, amount of debt already accounted for), and rating companies such as Moody’s or S&P help determine a company’s default risk.
|LP = Liquidity Premium||LP=Liquidity Premium |
If a company is relatively small or unknown, there may not be much interest in lenders in taking a risk. As a result, bond markets will have little interest in extending credit. This makes the company’s debt “illiquid.”
Liquidity Premium (LP) is not a major concern for larger companies. The more “illiquid” (i.e., the harder it might be to convert the debt security into cash quickly by finding a buyer), the larger LP is.
|MRP = Maturity Risk Premium||MRP=Maturity Risk Premium|
Maturity Risk Premium (MRP) compensates lenders for the risk that interest rates will change in the future. The further out a loan is extended, the higher the MRP, compensating for this uncertainty.
Borrowing Short or Borrowing Long?
Companies, especially corporate treasurers, need to concern themselves with other factors when deciding whether to go to banks or the capital markets to borrow.
As noted in the previous table, maturity risk premiums tend to make long-term rates higher than short-term rates. The rate on a 15-year mortgage, for instance, is likely to be lower than on a similar 30-year mortgage.
Put yourself in the position of a lender. Imagine that you have money to lend. Imagine you are lending half of your money for one year and the other half for five years. In this situation, you will be more concerned with the chance that the market short-term interest rate will go up over the five years than over the one year. Therefore, you will want to charge extra interest (a maturity risk premium).
The Question of Yields
The term structure of interest rates describes the relationship between long- and short-term rates. This relationship is an important consideration for a company looking to borrow funds.
The status of short-term vs. long-term rates will help determine whether to incur short-term or long-term debt.
If interest rates (yields) are plotted against their respective terms (years to maturity), the result is called a yield curve. Yield curves for corporate bonds and government bonds are depicted in the following graphic:
As in this example, yield curves are often upward sloping. However, this is not always the case. Sometimes yield curves are flat, and, on rare occasions, long-term rates are below short-term rates. This latter phenomenon is known as an inverted yield curve.
Some economists and investors believe that inverted yield curves indicate future declining economic conditions. However, their critics quip that inverted yield curves have been successful in predicting 10 out of the last 15 recessions!
How can a yield curve become inverted when maturity risk premiums are always positive?
Certainly, default risk premiums are also positive: while no one would expect a company like Chevron to go bankrupt in two or five years, anything can happen in 30 years (just look at U.S. airlines). And liquidity risk is not a significant factor for large companies.
So, what is the answer?
Economists believe part of the answer lies in inflation. Remember we said that k is a nominal rate: it includes a premium for expected inflation (investors want to be compensated for the loss in buying power of their dollars, too). Lower inflation expectations— which also suggest a slowing economy— lead to inverted yield curves. Click on the icon below to reveal a graphic that explains the phenomenon.
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To test your understanding of the content presented
1. Which of the following is NOT a reason that the interest rate a corporation must offer on its bonds is greater than the “risk-free” interest rate offered on short-term treasury bonds?
Choose only one answer below.
a. There is a risk that the corporation will go out of business before the bond matures
b. Investors face the risk that they might not be able to easily sell a bond when they need cash
c. Future interest rates might be higher
d. Inflation is expected to be lower in the future
Correct. The “risk-free” interest rate already includes a component to compensate investors for inflation. Moreover, expectations of lower future inflation rates make bonds a better investment, meaning that a corporation needs to offer a lower interest rate to attract investors.
2. Which of the following describes Default Risk Premium?Choose only one answer below.
a. Interest rates will change in the future.
b. A company will not pay back a loan.
Correct. Default Risk Premium is the risk that a company will not pay back a loan.
c. The cost of risk will rise.
d. None of the above
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