Cost of Capital: A Societal Perspective

Cost of capital is the most important concept in corporate finance. Essentially, it means that we cannot use the interest rate of our borrowing as the cost of our capital. When a company face financial trouble, we will layoff workers and cut dividends first. We still have to make interest payment on our debt. The interest rate of our borrowing is relatively low because its payment is safer than the other parts of payments, such as to workers and to equity owners. The overall cost of capital is higher than the cost of debt. When we borrow too much money, the risk of equity owners, who are left holding the bag, will increase. The overall risk of a business will increase with too much borrowing. In a debt ridden business, workers are less likely to get raise in their pay. They are more likely to get laid off.  Workers are less committed to their jobs. Customers and suppliers are more wary.

The concept of cost of capital is generally applied in corporations. But this concept can be applied to general society as well. Nowadays, governments often borrow heavily to finance various programs. US government debt to GDP ratio is over 100%. Japanese government debt to GDP ratio is over 200%. Many economists state that since the interest rates on government debts are so low, it is a good deal to borrow more money. However, from the theory of cost of capital, we cannot use the borrowing rate as the cost of capital. With too much government borrowing, the risk of equity owners, who are supposed to be the whole population of the society, will increase. In the last several decades, the pay for workers is stagnant or declining, such as in Japan.  The labor participation rate is declining over time.

At a more fundamental level, the US fertility rates have been lower than two per woman for more than a decade. In the past, US fertility rates had been temporarily lower than two in difficult times, during 1930s and 1970s. However, this time, US is amid the longest bull market in history. It means that even in a boom, people are less committed to have children, the long term future of our society. In many other wealthy countries, their fertility rates have dropped below replacement rate for a long time. Their populations are aging rapidly. Such populations are unsustainable.

From the theory of corporate finance, we learn two things. First, the cost of capital is higher than the cost of borrowing. Second, too much borrowing will weaken the long term viability of our future. They apply to individual corporations, as well as the whole society.