Essay on Corporate Cost of Capital

The structure of interest rates is defined as the relationship between interest rates or bond yields and the different timelines or maturities (Malkiel, 2015). The terminology term of interest also referred to as the yield curve which plays an integral role in a countrys economy. Moreover, the yield curve often used a benchmark for the credit market as it is used to report on the return risk-free fixed income investments done across different maturities. The yield curve is further employed in the credit market by lenders and banks to give a prediction of the people lending and saving rates (Malkiel, 2015). The U.S Treasury the yield curve is significantly influenced by the Federal Reserves federal funds rate. The relationships established between the interest rates and maturities, market participants can gauge their expectations and make predictions concerning the future changes of their assessment of monitory policy conditions and also interest rates.

Investors are keen on a company Weighted average cost of capital (WACC) which is the average after-tax cost of a company different capital sources inclusive of stocks, bonds, and any other long-term debts (Frank and Shen, 2016). The government has a direct influence on a company WACC as it moderated long-term interest rate through Federal Reserve Bank. This is conducted by making flat federal funds rates with the expected targeted rates by making either additions o subtraction from the money supply in the market through open market operations example selling or buying of U.S government securities.

The fixed mortgage loans which are preferred by many US home buyers have been preferred by many banks over the years as the banks do not have to bear the risk of financing long-term assets with their short-term funds (Tomlinson, 2015). Evidenced with the bank's removal of long-term mortgage loans from their balance sheet. The US is different in its mortgaging plans in contrast to other euro are governments who do not take action to reduce banks funding costs of a mortgage or allow the removal of loans from banks balance sheets. Therefore, the US federal government operations in the economy directly influence the mortgage markets as it directly affects the banks issuing mortgage plans to the people. The term structure of interest rates and the direction of the yield curve can be used by the mortgage lenders to judge on the overall credit market environment in the country (Tomlinson, 2015). When a flat curve characterizes the yield curve with an indication that the longer-term rates are falling when compared to short-term rates which have direct implications with the recessions. However, when the yield curve indicates an inversion, this illustrates that the short-term rates are beginning to exceed the long-term rates and it is an illustration there is a high likelihood of a recession approaching (Swanson and Williams, 2014). Therefore, the banks are well conversant with the yield curve so that they can know when to offer mortgage plans to the customers, at what interest rates based on the future predictions and also when to remove their mortgage loans from their balance sheet and forward to the federal government.

When the federal government moderates the interest rates, they can potentially cause fluctuations in the risk-free rate. This can potentially affect a company WACC as a risk-free rate is an integral aspect when calculating the cost of capital for the particular business (Harris and Harris, 2017). Therefore, this can translate to the company having changes when making predictions on future costs for capital as a result of the rate on debt fluctuating. Thus rendering to the company having greater or lesser capital costs which are not according to their expected due to the fluctuations in the interest rates. In conclusion, there is a direct link in the relationship between the corporate cost of capital (WACC) and the government and mortgage finance markets.

References

Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), pp.300-315.

Harris, R.S. and Harris, R.S., 2017. A Comparison of the Weighted-Average Cost of Capital and Equity-Residual Approaches to Valuation. Darden Business Publishing Cases, pp.1-5.

Malkiel, B.G., 2015. Term structure of interest rates: expectations and behavior patterns. Princeton University Press.

Swanson, E.T. and Williams, J.C., 2014. Measuring the effect of the zero lower bound on medium-and longer-term interest rates. The American Economic Review, 104(10), pp.3154-3185.

Tomlinson, J., 2015. New Research: Reverse Mortgages, SPIAs and Retirement Income. Advisor Perspectives, Inc, April, 14.