The New Environments

Sources of Investment Funds

Why Interest Rates are Different

video transcript of Sources of Investment Funds

Why Interest Rates Are Different

Up to this point we have assumed that the MARR account has an infinite size, but this is not the case. A few separate sources are generally needed for investment. These sources of funds are as follows, from cheapest to most expensive.

Retained Earnings: Investors with more uncertainty have a higher perception of risk. Retained Earnings is least expensive primarily because the investors are very tightly bound with the business. They know the specifics of the business, the current projects, and the strengths and weaknesses of each project. They also know you and your strengths, weaknesses, and biases. Because of their more detailed understanding of the investment being made, there is less perception of risk and it is usually cheaper than other sources.

Bank Loans: Bank loans are the next cheapest because bankers often specialize in specific industries and gain a lot of information both about the industry and about your particular firm. You develop a reputation and relationship with the banker so they understand a lot of what you are doing. But these are more expensive than funds from Retained Earnings because they have less knowledge and are a little more uncertain about the final result.

Capital Market: This is issuing bonds and issuing stock. These investors are more uncertain because they don't know the specific details of the project and they don't know the specifics of the industry. Because of the uncertainty the interest rate will be higher than the previous sources of funds. The next section will explain why we can put bonds and stocks at the same level.

The Capital Structure

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The Capital Structure

(1)
\begin{align} Debt Ratio=\frac{Total Liabilities}{Total Assets} \end{align}

Bond and dividend rate is a balancing process. The bond rate rises as the debt ratio increases because with higher debt comes higher risk. The dividend rate falls as the debt ratio increases because more debt means more leverage which will increase returns.

Let's say a company has a relatively low debt ratio. At that point bonds would have a significantly lower interest rate than dividends, so they issue bonds. As they issue more bonds, their debt ratio rises until the two interest rates cross and now the bond rate is more than the dividend rate. The crossing point is your ideal capital structure. If your debt ratio is higher than this point, the dividend rate would be lower so you'd issue stock and the debt ratio would be lowered. If your debt ratio is lower than this point, the bond rate would be lower so you'd offer bonds and the debt ratio would rise. This is why bond and stock rates are typically the same.

Ideal Capital Structure: the debt ratio that minimizes your cost of funds.

The Two New Environments

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