Introduction:
The corporate cost of capital often referred to the WACC is the rate of return that is required by the firm's investors. It is the weighted average of the firms cost of equity and debt. When a firm is making capital budgeting decisions, the firms WACC is the benchmark rate used to determine the feasibility of a project. Projects which present with an amount higher than the firms WACC are accepted. The recent financial crisis relating to the US subprime mortgage crisis had an unfounded effect on the survival of many financial and non-financial institutions. As such it is reasonable to examine the interest rate effect which can have an impact on the firms cost of capital and how it relates to the financial markets.
The Government Securities Market:
The government securities market consists of a primary market and a secondary market. Government securities play a vital role in the economy as it provides a benchmark interest rate which is the risk free rate of which all other interest rates are set and remain a key factor in the monetary policy of most countries (UOL Lecture notes, 2011). The primary market focuses on the new issues of government securities which involve long, medium and short term issues. The secondary market involves the sale and purchase of already existing securities (UOL Lecture notes, 2011).
Mortgage Financial Markets:
Various types of mortgages have been available to consumers for years. Although in the US mortgages were predominantly handled by Savings and Loans Institutions, through the issuance of fixed rate and adjustable rate mortgages, risk factors such as interest rate hikes, drops, prepayment and defaulting often created liquidity issues. As such a secondary market was developed for the most part by the federal government which was aimed at securitizing mortgages enabling them to be sold in a secondary market (Kohn, 2004, p.381). By doing so, it enabled the banks and thrifts to continue to offer mortgages, but also offered a means to hedge interest rate risk by selling the mortgages to long-term investors who were able to manage this risk more effectively.
Although the creation of the secondary mortgage market worked well for the mitigation of interest rate risk, the government's intentions of this market were more so to accommodate certain classes of borrowers in certain geographic areas (Kohn, 2004, p.382). Large associations were formed by the fed such as Fannie Mae and Freddie Mack in order to accommodate this secondary market while also providing insurance backed mortgages. When the parallel mortgage market began to decline, the government moved to develop a market for public issues and as such created mortgage backed securities which opened the market for non insured mortgages. Further innovations were later added such as the collateralized mortgage obligations which were a more appealing option to life and pension fund investors.
While this market proved very lucrative and was deemed an efficient and relatively safe means of meeting supply and demand, the demise of the market became quickly evident because the demand for mortgages came to a halt. The resulting effect was that real estate value dropped and investors that had invested in the CDO's and MBS's which promised higher yields were now left with assets that were less than their original value and the high rate of default only promised losses. The US Subprime crisis could largely be blamed on irresponsible lending practices that ended up in massive defaults which in turn created severe liquidity issues. This not only had dire consequences on the economy locally, but also globally.
The Cost of Capital:
The firms cost of capital relates to the weighting of the amount of equity it employs as well as debt. Interest rates are normally benchmarked against government securities. An increase or decrease in interest rates can influence the firms cost of capital. However, this is highly dependent on the age, industry and size of the firm. For example if a firm relies on bank funding or loans that are linked to short term money market interest rates, it will have an impact on the firm's profits. Increased interest means increased obligation, which in turn increases the required rate return that a firm will need on any new investments it enters into (Lipsey et al, 2007). Likewise a decrease in interest rate could offer an incentive to enter into a financing venture for growth opportunity.
Not all firms are susceptible to increased interest rates. If a firm is cash rich and interest rates have increased, such a firm will benefit from deposits held at banks or investment firms, thus increasing cash flow to enter into lucrative opportunities (Lipsey et al, 2007). Large multinational firms would have faired better as well due to international capital markets access (Lipsey et al, 2007). However, cash constrained firms which relied on short-term financing had major issues due to tightening of the lending policies, and many of these firms failed.
Reverting back to the US subprime mortgage crisis it brings to mind whether this had an impact on the firms cost of capital. Reviewing the link between interest rates and corporate and government bonds, it was earlier noted that most countries and firms rely on the government bond as a benchmark for interest rate. This too can have an effect on the firms cost of capital. One way the interest rate is measured is by the default spread. The default spread is the difference between the corporate bond interest rate against a government bond of similar maturity and is normally interpreted through basis points. In times of an economic recession, default spreads tend to widen and lessen in times of market boom (Damodaran, 2010, p. 434). As such, an increase or decrease in spreads will have an impact on the optimal debt ratio. When the crisis occurred, it resulted in wider spreads which in turn lowered the optimal debt ratio. Thus a firm who had high leverage would ultimately end up with a lower rating (Damodaran, 2010, p. 434). Increased spreads also lower the firms borrowing power, and if a firm cannot borrow it may increase the chances of failure and decreases expansion ability.
Conclusion:
In conclusion I would like to bring a thought across in relation to the US government financial market. In light of the crisis, one of the things the government had to do was to issue more debt in order to save face. An interesting article written by Avery (2008) suggested that even though US government securities have always been deemed to be relatively safe, it brings to question how creditworthy they will be due to the expanded supply of government debt. They can continually expand their market debt, but what if there isn't enough demand for them because investors lack confidence in their creditworthiness? Will this result in the demise of the US sovereign market, or will they be able to restore investor confidence, and at what cost? One suggestion offered by Bernanke recently is for the Fed to repurchase medium term notes; a tactic known as Quantitative Easing (Hilsenrath et al, 2010). The reasoning behind this would be to "drive down long term interest rates by pushing up the price of Treasury bonds thus driving down the yields", which should benefit the economy. However one drawback to this is to print more money to accommodate the purchase which could likely affect the value of the dollar, as well as increase inflation.
