In 2022, the Federal Reserve Bank has taken an aggressive stance on increasing interest rates to help curb inflation. In March 2022, the Fed funds rate was increased by 0.25%, followed by a 0.5% increase in May and a 0.75% increase in June — the biggest hike since 1994. More increases are expected in the second half of the year. How will higher rates and increased stock market risks affect your company’s financing decisions?

Evaluating Financing Options

There are two options to finance a business:

1. Debt. In general, debt is the less expensive option, because secured creditors are paid first in a liquidation, and they receive a guaranteed streams of principal and interest payments. Plus, interest payments are generally tax deductible (within limits imposed by the Tax Cuts and Jobs Act). Business owners may be hesitant to take on debt, as it adds risk to the business. But a reasonable level of debt enables borrowers to grow quickly and build value for equity investors.

2. Equity. Equity investors demand a higher return — currently at least 10% and often closer to 20% — to offset their incremental risk. And, unlike interest payments, dividends aren’t tax deductible. Investors also may have more control over business decisions (via voting rights) than lenders.

The cost advantage of debt over equity disappears at higher levels, however. That is, the cost of uncollateralized, underfunded loans will eventually equal or outpace the cost of equity.

The theory of optimal capital structure suggests there’s a specific blend of debt and equity that will minimize your company’s overall cost of capital and, therefore, maximize its value. The right blend of debt and equity financing evolves with changes in your company’s operations, its industry and the overall markets. CFOs must regularly evaluate their companies’ capital structures to determine whether adjustments are needed.

Adjusting Financial Models for Market Trends

In today’s marketplace, some companies may decide to rely more on equity financing — or to convert loans from variable to fixed to prevent the cost of debt from spiraling out of control. It’s also important to work with lenders to adjust loan covenants as needed to take advantage of smart financing opportunities.

Market volatility may cause a company’s cost of equity to spike, too. Increased risk may trigger investors to demand a higher rate of return. Companies with excess cash may decide to repurchase stock to reduce the amount of stock outstanding, rather than pursue growth opportunities.

Additionally, it’s important to adjust the “hurdle rates” used to evaluate capital investment decisions for changes in today’s debt and equity markets. Increases in the cost of capital may cause companies to tighten their purse strings. CFOs should pursue investments — such as major equipment purchases, new product launches and M&A transactions — only if the project will earn a return that’s higher than the projected cost of capital to finance it.

Seeking Outside Assistance

Our CFO Services team can help you evaluate your company’s current capital structure and hurdle rates. We can help you pivot based on current market trends and fortify your company’s financial position in today’s uncertain markets.