Key Takeaways
- Interest rates affect the cost of debt capital, influencing a company’s capital structure.
- Companies choose between debt and equity based on the cost of capital.
- Debt capital is attractive because interest payments are often tax-deductible.
- Debt financing usually has a lower cost of capital due to reduced risk compared to equity.
- Rising interest rates can shift a company’s preference from debt to equity financing.
Interest rates primarily influence a corporation’s capital structure by affecting the cost of debt capital. Companies finance operations with either debt or equity capital. Equity capital refers to money raised from investors, typically shareholders. Debt capital refers to money that is borrowed from a lender. Common types of debt capital include bank loans, personal loans, credit card debt and bonds.
Low interest rates can favor debt over equity in a corporation’s capital structure, and changes in interest rates can lead to adjustments in corporate financial strategies.
Cost of Capital: Debt vs. Equity
A certain price must be paid for the privilege of accessing funds when using either debt or equity; this is called the cost of capital. For equity capital, this cost is determined by calculating the rate of return on investment shareholders expect based on the performance of the wider market and the volatility of the company’s stock. The cost of debt capital, on the other hand, is the interest rate lenders charge on the borrowed funds.
The Impact of Interest Rate Changes on Corporate Debt
Given the choice between a business loan with a 6% interest rate and a credit card that charges 4%, most companies opt for the latter option because the cost of capital is lower, assuming the total amount of borrowed funds is equivalent. However, many lenders advertise low-interest products only to divulge that the rate is actually variable at the issuer’s discretion. A capital structure including a credit account with a 4% interest rate may need to be significantly revised if the issuer decides to bump the rate to 12%.
One benefit of debt capital is interest payments are usually tax-deductible. Even if interest rates rise, the cost is partially offset by the reduction in taxable income.
Balancing Risk: Debt vs. Equity Financing
Because payments on debt are required regardless of business revenue, the risk to lenders is much lower than it is to shareholders. Shareholders are only paid dividends if the business turns a profit, so there is a possibility the investment will fail to generate adequate returns. Due to this decreased risk of default, most debt financing options still carry a lower cost of capital than equity financing unless interest rates are particularly steep.
Therefore, if interest rates are low enough or offer enough of a tax deduction to make debt capital more attractive to a company than equity capital, the company’s capital structure may change to favor the former over the latter. If interest rates increase, making debt capital cost more, the opposite can also occur.
The Bottom Line
Interest rates primarily impact a corporation’s capital structure by influencing the cost of debt capital. Companies often prefer debt over equity due to typically lower costs and tax-deductible interest. If interest rates rise, debt becomes more expensive, potentially shifting a company’s preference towards equity.
For related reading, see “Debt Financing Versus Equity Financing: Which Is Cheaper?”