Post writer: Lisa Lumley
Cost of capital and international competitiveness
The analysis of cost of capital is essential in the firm’s capital budgeting process. Cost of capital is the cost of funds used for financing a business venture (Demirkan, et al, 2012). A company decides to source capital either through equity or cost of debt. Many companies practice using a combination of both, in order to finance their business ventures. A company must overcome its cost of capital before it can make revenue and create value. Cost of capital is used to determine the profitability of a project before the company proceeds with undertaking it.
Every multinational company thrives to be competitive in the international market. Without this competitiveness, companies will fail at achieving profitability and value.
The cost of capital can both negatively and positively affect a firm’s international competitiveness as it affects the overall cost of production. Salvatore (2012), states that cost of capital is one of the main factors to affect international competitiveness, as seen in the 1980s. if the cost of capital is high then this would negatively impact the repayment of the lending rates for the capital due to inflation. The high cost of capital would greatly increase the repayment cost as inflation would add significant amount of dollars to the interest rate. The high repayment costs would negatively impact the firm’s profit and make it less competitive in international markets and even in its local market.
Most companies find it necessary to seek funding for capital through borrowing, and are then faced with high interest rates which affect their ability to repay at these high interest rates as well as realizing a substantial profit for the company. This has caused many firms to fail in the international market as they find it increasingly difficult to compete with more financially viable businesses.
Companies who have to carry out high levels of Research and Development such as pharmaceutical companies such as GlaxoSmithKline and AstraZeneca are finding it difficult to stay ahead in the market due to the high capital cost. The cost of introducing a new drug into the market costs approximately US $1.8 billion (Herper, 2012).
Interest rates and investment opportunities:
As we have seen, interest rates affect the competitiveness of firms, they also affect the opportunities firms have for investing capital.
There are two forms of interest rates – nominal and real.
Nominal interest rates are interest rates quoted before taking inflation into consideration. This rate is used in negotiating bonds etc., but are not effective in determining the overall costs of doing business in international markets or for calculating actual costs of capital.
Real interest rates are affected by inflation and such are highly fluctuated (Salvatore, 2012). This gives a more ”real” impact on cost due to inflationary effects. This is the rate considered when determining international competitiveness.
The increase in demand for real interest rates can lead to investment opportunities in an economy facing budget deficits. Interest rates become high due to increased demand for borrowing and lower supply of loanable funds (Salvatore, 2012). This creates a deficit in the economy which leads to lower savings rate in order to attract investments.
Conclusion:
The demand for loans affects the interest rates charged which also will affect the investment opportunities available to the firms. Companies can however counter the negative effects of high interest rates by creating efficiency in their industry.
References:
Demirkan, et al (2012). “Discretionary Accruals Quality, Cost of Capital, and Diversification”. Journal of Accounting, Auditing and Finance 27(4) 486-526.
Herper, M. (2012).”The truly staggering costs of inventing new drugs”.
Salvatore, D. (2012).’’Managerial economics in a global economy”. 7th ed. New York: Oxford University Press.