Cost of capital: What can a firm do?

Financial markets give capital to different borrowers at different prices. This is obviously evident in debt, where a bond issued by firm A may offer a return of 20% while a bond issued by firm B could run at 11%. The cost of equity capital is also sharply different across firms. The simplest way to see this is to compare P/E ratios. A firm with a P/E of 100 is getting capital at a much lower price than a firm with a P/E of 10.

Why is the cost of capital different across firms? One key factor, obviously, is risk. A riskier project will require a higher return, i.e. a risk premium. In addition, there is a liquidity premium. A more liquid security requires lower returns, in the eyes of an investor, than a less liquid security.

Many aspects of risk premia and liquidity premia are determined in the economy as a whole. Sound macro-economic management reduces volatility of the equity index, which should reduce the equity premium in the long run. Improvements in financial infrastructure, such as the depository, reduce the cost of transacting, which yields higher securitiy prices for all issuers. These issues are played out in the Finance ministry, and not the firm.

What can a firm do to improve it's own cost of capital? Modern finance has produced important insights into the behaviour of financial markets, which can be usefully applied into improving financial strategy at the level of a firm. This has strong consequences. Suppose firm A and B are competitors. If B faces a lower cost of capital than A, then it enables B to compete more effectively, by investing in more long-term and more risky projects. Hence, firms should benchmark themselves against their competitors on the question of cost of capital.

Woo international shareholders. For an Indian shareholder, Air India will always be more risky than Lufthansa. Shocks to India's economy affect Air India, and also affect the wealth and income of the Indian shareholder. In contrast, shocks to India's economy do not affect Lufthansa, while shocks to the German economy do not bother the Indian shareholder. Hence, the Indian shareholder sees Air India as a more risky stock than Lufthansa and demands a lower cost of capital from Lufthansa. This same argument applies in reverse also: German shareholders will require a lower rate of return from Air India than that required from Lufthansa.

This suggests that a firm can obtain a lower cost of capital by attracting international shareholders. What can an Indian firm do towards this goal? Firms should try to place primary issues of shares or bonds with foreign investors, and improve their own visibility in the eyes of foreign investors. India's policy-makers have placed many hurdles aimed at reducing foreign investment into India. Every firm should undertake actions which maximise foreign investment despite these policies. Specific initiatives which are relevant as of today include passing a shareholders resolution to lift the cap on foreign shareholding above 24%, and issuing GDRs or ADRs.

A firm can compare itself against its competitors on this question using CMIE's Prowess database, which gives data on foreign shareholding for all companies.

The next area where firms can influence their own cost of capital is liquidity. The best measure of liquidity is the bid-offer spread. A security with a tight bid-offer spread is more liquid than a security with a wide bid-offer spread. A firm can compare itself against its competitors by taking readings of the spread from an NSE terminal.

Liquidity is affected by two major factors: the number of investors and asymmetries in information amongst speculators.

A larger number of owners of a security benefits liquidity of the security. It may seem easy for a company to knock on the doors of a few large investors in placing a primary issue. But this comes at a cost, which the company will suffer for life, in terms of a liquidity premium. It is very difficult to change over to a widely dispersed retail ownership structure after an issue is completed. This suggests that firms should emphasise large-scale retail distribution of bonds or shares, even if it entails somewhat higher issue costs.

Many companies have regional pockets of investors. A company in Orissa may have an accent on shareholders from Orissa. This is an unsatisfactory outcome, for reasons similar to the Air India / Lufthansa example. With 3000 NSE terminals all over India, India's financial markets are now truly distributed all over India, and every firm should seek to harness retail investors from all over the country. There are policy impediments to having German shareholders - in contrast, there is nothing that holds back investors from anywhere in India.

Finally, asymmetries in information have a major impact upon liquidity. If different participants on the secondary market have differential access to information about the firm, this is known to have a sharp and negative impact upon the liquidity of securities. Firms should be very careful about this issue, in a variety of policies:

In summary, the cost of capital matters greatly to firms, and there are things that a firm can do to impact upon its own cost of capital.

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