Question

How does the cost of money affect the value of an asset?

Answer 1

Answer:

Cost of money and value of assets are inversely related. If cost of money increases value of assets goes down.

One way to determine value of assets is based on future stream of cash flows it will earn.

Cost of money normally is the rate of interest. If money is sourced from various sources cost will depend on its composition and costs of each of such sources.

In a simple example:

Let us assume we want to buy an asset which earns $1000 each year perpetually and

Cost of money = rate of interest = 10%

Then, Value of asset = Annual cash flow / Cost of money = $1000/ 10% = $10,000

Here if cost of money increases from 10% to 12.5%,

Value of asset will decrease to = $1,000 /12.5% = $8,000

Similarly of cost of money decreases from 10% to 8%,

Value of asset will increase to = $1,000 / 8% = $12,500

Thus when cost of money increases, value of assets decreases and vice-versa.

When we use discounted cash flow model to arrive at value of assets like plant & machinaries, land, commercial establishments etc the factors that determine the value are the stream of earnings/Cash flows, growth and the discounting rate (cost of money). Similarly when we use CAPM model to value shares the factors that determine value of share are stream of dividends, growth and cost of money (required rate of return).