Question

Considering that interest rates today have dropped significantly from the September 2019 timeframe, what would you do as a corporate finance professional with your firm’s capital? From an issuers standpoint? From a corporate investment standpoint?

Answer 1

Sol:

From Corporate Investment standpoint

Interest rates primarily influence a corporation's capital structure by affecting the cost of debt capital. Companies finance operations with either debt or equity capital. Equity capital refers to money raised from investors, typically shareholders. Debt capital refers to money that is borrowed from a lender. Common types of debt capital include bank loans, personal loans, credit card debt and bonds.

A certain price must be paid for the privilege of accessing funds when using either debt or equity; this is called the cost of capital. For equity capital, this cost is determined by calculating the rate of return on investment shareholders expect based on the performance of the wider market and the volatility of the company's stock. The cost of debt capital, on the other hand, is the interest rate lenders charge on the borrowed funds.

Given the choice between a business loan with a 6% interest rate and a credit card that charges 4%, most companies opt for the latter option because the cost of capital is lower, assuming the total amount of borrowed funds is equivalent. However, many lenders advertise low-interest products only to divulge that the rate is actually variable at the issuer's discretion. A capital structure including a credit account with a 4% interest rate may need to be significantly revised if the issuer decides to bump the rate to 12%.

One benefit of debt capital is interest payments are usually tax-deductible. Even if interest rates rise, the cost is partially offset by the reduction in taxable income.

Because payments on debt are required regardless of business revenue, the risk to lenders is much lower than it is to shareholders. Shareholders are only paid dividends if the business turns a profit, so there is a possibility the investment will fail to generate adequate returns. Due to this decreased risk of default, most debt financing options still carry a lower cost of capital than equity financing unless interest rates are particularly steep.

Therefore, if interest rates are low enough or offer enough of a tax deduction to make debt capital more attractive to a company than equity capital, the company's capital structure may change to favor the former over the latter. If interest rates increase, making debt capital cost more, the opposite can also occur.

From Issuer Stand Point:

Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. ... And as the supply of credit increases, the price of borrowing (interest) decreases