Post Writer: Alexandra
Cost of Capital & International Competitiveness
The cost of capital is defined as “the cost of obtaining funds, through debt or equity to finance an investment” (Boundless, 2014). Debt is the amount of money a company, government or country borrows, and equity is the selling of bonds (for governments) or shares (for companies). Often cost of capital is called the “hurdle rate” as it is the minimum rate of return (before tax) that it needed before an investment will even be considered by managers (Shoven & Topper, 1992). There are three common tools for measuring the cost of capital; these are: “the real interest rate, the tax-adjusted real interest rate, and the weighted-average cost of capital” (Shoven & Topper, 1992).
The cost of capital is one of the most important factors in measuring the international competitiveness of an organization (Salvatore, 2012). The reason for this is because most businesses need financial assistance in order to begin and to grow (Calgary Chamber, 2014). If capital funding is low, costs are high and there are limited margins, the company will be less able to invest. A larger access to capital allows businesses to thrive further and invest more.
As the cost of capital determines the amount of investment that takes place in the economy, it also means that cost of capital sets economic growth and real wages too (Shoven & Topper, 1992). As a result, when productivity growth is slow, cost of capital being too high is often to blame.
Interest Rates & Investment Opportunities
Interest rates and the volume loanable funds are one of the most important factors that influence cost of capital and the level of international competitiveness. When the demand for loanable funds is higher than that of supply (e.g. if there are many investment opportunities available), it means that the increase rates must increase so as to balance supply and demand (Salvatore, 2012). When interest rates increase, the cost of capital will also increase. This can result in a failure to generate high returns and lower profits. It will also mean less investments will take place, as when the rate of return is lower than that of the interest rate, the investment is not worthwhile or profitable (Khan Academy, 2014). According to Salvatore (2012), even a 1% change in interest rates could increase the cost of capital by hundreds, thousands, sometimes even millions. This also applies the other way around; when interest rates are low, investments will increase and in theory so will international competitiveness.
For example, Japan is “the world’s largest capital market participant” (Shoven & Tooper, 1992), and they have managed to achieve this by having extremely low interest rates. According to Oi (2012) interest rates in Japan have been almost 0 since the middle of the 1990s. This however, has not resulted in large international competitiveness for Japan. The reason for this is because, yes it is easy and cheap to borrow money, but there is not a enough need to borrow this money as there is not sufficient investment going on (Oi, 2012). The other issue is that the yen has strengthened hugely in comparison to the dollar (from 144 yen to 1 dollar, to 78 yen to 1 dollar in just 4 years) (Oi, 2014). This means that prices are extremely high for overseas customers, making Japan less competitive internationally. As the interest rates are already so low, it is not possible to increase them further to decrease the value of yen.
Overall, when the cost of capital is high, the international competitiveness of the organisation, government or country will be weakened. When interest rates are high, this will also increase the costs of capital, resulting in less investment opportunities.