Tuesday, 2 December 2014

INTEREST RATE AND CORPORATE FINANCE



2. 1.2 INTEREST RATE AND CORPORATE FINANCE

There is no doubt a theoretical link exist between interest rates and the financial structure of firms. Interest rate operate through their influence on the cost of capital to the investors as well as a returns to various groups of savers. A change in the interest rate affects the debt-equity choice of a firm, the overall cost of capital and real interest rates,
and thereby sets in motion a chain of responses influencing the desired level of the capital stock and consequent speed of adjustment of the actual capital stock to its desired level. The debt-equity ratio is important because the overall cost of capital to investors, which influences fixed investments, their efficiency and profits can be expressed as a weighted sum of the opportunity cost of bank debt and of equity, with the weight depending upon the debt equity ratio. Therefore, the multiple effects of changes in the cost of bank debt, on the overall cost of capital, depend among other things on the overall cost of capital, depend among other thing on the share of debt in investment financing and on the induced adjustment in this share and in the cost of equity. Further, the cost of equity is said a corporate a risk premium that first falls and then rises as the debt-equity ratio rises. The resulting U- shaped cost of capital has been proved to have far-reaching implications for the effectiveness of interest rate policy (Sundararajan, 1987).


In general, the desired debt-equity ratio will be positive related to the implicity interest subsidy on credit from the regulated financial markets. Therefore, the direct effects of interest rates on savings and investment can be reinforced or off set by the substantial indirect effects a rising from the optimal adjustments in the implicity interest subsidy, and hence induce a fall in the debt equity ratio. Other channels through which the interest rate influence the financial structure of firms include the nec-classical rentalwage ratio by which higher interest rate raise the relative price of capital and thereby encourage more intensive use of capital and capital labour substitution.


Another is the project evaluation mechanism by which higher real interest rate may improve the quality and efficiency of bank credit retaining, thereby weeding out projects that were profitable only with lower interest rate and encouraging those with higher yields. The financial depending that directly influences factor productivity through higher real rates of interest is another channel, and finally, there is the portfolio choice that diverts savings from low-yielding self-financed assets, through higher yields (Mckinnon, 1973, Shaw 1973) Try, 1982, Sundararajan 1987). From all indications however, the link between the interest rates and corporate capital structure as well as the pattern of influence of corporate  financing  strategies  on  the  effectiveness  of  interest  rate  policies, warrant  attention  because  of  its,  for  resource  mobilization,  production  and growth................
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