13.2 Interest Rates: Returns to Investors; Cost to the Corporation
13.2 Interest Rates: Returns to Investors; Cost to the Corporation
Interest rates, and, hence securities’ returns, are a function of economic circumstances that are manifest in the financial markets. Return to investors represents cost to the corporations that issue the securities; they are the two sides to the same coin. As in the case of “return on investment,” the phrases “return” and “cost of capital” to a corporation are described in percentage terms, i.e., as a rate, and not as a dollar amount. Cost of capital refers to the weighted-average cost of the corporation’s debt and equity.
Both debt and equity provide the corporation with funds with which to acquire assets, so that the corporation may grow. Investors who provide these funds to the corporation expect a return on their investment; this return represents an “economic cost” to the corporation. The money is not free. “Economic Cost” is a financial term, not an accounting term such as “expense,” and should be understood differently.
- The cost of debt capital to the corporation is the after–tax cost of interest paid on the debt.
- The cost of equity capital includes the dividends paid to investors plus their expectations of capital gains resulting from the growth in earnings. Remember, shareholders may expect to receive dividends and to see additions to retained earnings. Should the investors’ expectations, which we may also view as their minimum required return, not be met, they may sell the security.
Investors expect that retained earnings and other capital sources be productively employed in the growth of the company so that their shares’ value increases – due to increased earnings and growth expectations. Corporations therefore must provide the assurance of price appreciation, or shareholders will sell, and/or hire new managers and directors. This prospective price appreciation is also part of the firm’s capital costs, as viewed from the economist’s eye.
In general, the required return (R) whether for stocks or bonds, consists of two parts: one, a return associated with the “risk-free” instrument and the risk-free rate of return (RF); the other, a premium, or extra, return for incremental risk above zero-risk. That is, the required return equals the risk-free rate of return plus a “market risk premium” (MRP).
R = RF + MRP
MRP = RM – RF
Here, you will find a graph that depicts these concepts.
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- The phrase “risk premium” (referring to RM – RF) is a bit of a misnomer, as the term “risk” draws your attention toward the horizontal axis rather than the vertical axis where the premium (-return for incremental risk) is observed.
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- The “Market Risk Premium” (MRP) = Market Return (RM) less Risk-free Rate-of-Return (RF).
- In the graph above, we have risk (a quantifiable measure) and return, which is measured in percentage terms. We also have the overall or average “market risk” and its corresponding market return.
There is also a theoretical zero-risk investment and its corresponding risk