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 possibilitythe 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 capitalmore 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. (For related reading, see"Debt Financing VersusEquity Financing: Which Is Cheaper?")
FAQs
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.
How the interest rates are impacting the capital? ›
If the interest rate is low, then the cost of borrowing is lower and generally will result in higher capital, because less money is paid back to the bank in the form of interest.
How do interest rates influence working capital? ›
With rising interest rates, businesses that manage to secure working capital loans may face higher borrowing costs. Increased interest rates directly affect loan repayments, potentially reducing the profitability of businesses and hindering their ability to reinvest or expand.
What are the factors affecting the structure of interest rates? ›
Factors that affect interest rates are economic strength, inflation, government policy, supply and demand, credit risk, and loan period. There are two standard terms when discussing interest rates. The APR is the interest you will be charged when you borrow. The APY is the interest you get when you save.
How do interest rates affect corporate profits? ›
Another way the interest rate environment affects stocks has to do with companies' bottom lines. If a debt-issuing company faces higher borrowing costs due to rising rates, it may result in reduced company profits, which can be reflected in lower stock prices.
How does interest rate affect capital account? ›
Because the acquisition of new capital is generally financed in the loanable funds market, a change in the demand for capital leads to a change in the demand for loanable funds—and that affects the interest rate. A change in the interest rate, in turn, affects the quantity of capital demanded on any demand curve.
Which of the following influence the interest rate on capital? ›
Demand for and supply of money, government borrowing, inflation, Central Bank's monetary policy objectives affect the interest rates.
What role do interest rates play in the availability of capital? ›
Interest rates can determine how much money lenders and investors are willing to save and invest. Increased demand for loanable funds pushes interest rates up, while an increased supply of loanable funds pushes rates lower.
How do interest rates affect capital flow? ›
When there are differences in real interest rates between two countries that allow for the flow of financial capital, that capital flows to the country with the relatively higher real interest rate and out of the country with the relatively lower real interest rate.
What are the three main factors that affect interest rates? ›
Factors Affecting Interest Rates:
Inflation: Rising prices prompt lenders to demand higher rates. Monetary Policy: Central banks influence rates by managing the money supply. Credit Risk: Borrowers' creditworthiness impacts rates.
Generally, as market interest rates rise, the value of the structured product will tend to decline. Conversely, as market interest rates fall, the value of the structured product will tend to rise. However, this relationship may not always apply, and may have no bearing on some structured products.
What happens when interest rates rise? ›
Higher interest rates can make borrowing money more expensive for consumers and businesses, while also potentially making it harder to get approved for loans. On the positive side, higher interest rates can benefit savers as banks increase yields to attract more deposits.
How are companies affected by interest rates? ›
Higher cost of capital: The cost of capital is the rate of return that businesses must generate on their investments to satisfy their stakeholders. When interest rates rise, the cost of capital rises as well. This makes it more difficult for businesses to justify new investments, which can slow long-term growth.
How do interest rates impact on a business and its decision making? ›
Although the impact varies, low interest rates are more favourable for businesses. This is because borrowing money to grow is cheaper, and it's easier to plan to repay what you've borrowed. Maintaining financial stability becomes difficult when interest rates climb faster than anyone predicts.
Do interest rates affect corporate bonds? ›
Bond prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.
How does interest on capital affect capital? ›
Interest on capital is considered as an expense for the business and is added to the owner's capital, which increases the overall capital of the owner in the business.
How does interest rate affect physical capital? ›
In turn, a higher interest rate tends to discourage firms from making physical capital investments. One reason government budget deficits crowd out private investment, therefore, is the increase in interest rates.
How do interest rates impact venture capital? ›
Higher interest rates have ripple effects on venture capital. First, investors' return expectations increase when they finance start-ups. Second, investors deploy less in venture capital and are more selective. As a result, investment activity has already started to decrease.
