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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