How Do Interest Rates Affect the Cost of Capital?

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Capital is the money invested in a business required to make the business function effectively. This capital can take many different forms, including debt and the amount of money spent on infrastructure or other equipment used to produce goods and services. Both of these expenses are affected by the prevailing market rate of interest on loans, although the former causes more of an effect, as it affects the amount of interest that must be paid on the debt.

Debt

Many businesses take on debt, both in the short term and long term, in order to make investments that will later bear fruit. While some of these loans are fixed-rate, meaning the amount of interest paid on them will never change, many are dependent on the prevailing rate of interest. As the rate of interest moves up, the business is required to pay more interest. This increase in the amount of interest paid on the debt is an increase in capital costs.

Predicting Capital Costs

Because the rate of interest on a debt may shift, this can make it very difficult for a business to correctly predict the future costs of capital. While a business can retroactively identify how much debt has previously cost, and use this information to estimate future costs of servicing future debts, the interest rates available to a company can shift quite quickly. Therefore, a business may be stuck with greater or lesser capital costs than expected due to changes in the rate of interest.

Oppurtunity Costs

The cost of capital can be measured in two ways: the actual amount of money tied up in debt and equipment, and the opportunity cost that comes from not using this money in other ways. For example, a piece of equipment may be worth $10,000. However, were the money tied up in that equipment to be used in another part of the business, it might earn the company $15,000. The interest rate affects this opportunity cost indirectly.

Savings

The interest rate and the rate of savings is inversely proportionate. This is because the higher the interest rate goes, the greater incentive a business has to save its money or to invest in interest-bearing bonds. The opportunity cost of money tied up in capital may increase when this happens, as the money would be worth more if invested or saved. However, when the interest rate drops, the business has a greater incentive to take on debt, increasing its capital costs.

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