The Cost of Money
by MaestriCapital in a free economy is allocated through the price system. The interest rate is the price paid to borrow debt capital. With equity capital, investors expect to receive dividends and
capital gains, whose sum is the cost of equity money. The factors that affect supply and demand for investment capital, hence the cost of money, are discussed in this section.
The four most fundamental factors affecting the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) in?ation. To see how these factors operate, visualize an isolated island community where the people live on ?sh. They have a stock of ?shing gear that permits them to survive reasonably well, but they would like to have more ?sh. Now suppose Mr. Crusoe has a bright idea for a new type of ?shnet that would enable him to double his daily catch. However, it would take him a year to perfect his design, to build his net, and to learn how to use it ef?ciently, and Mr. Crusoe would probably starve before he could put his new net into operation. Therefore, he might suggest to Ms. Robinson, Mr. Friday, and several others that if they would give him one ?sh each day for a year, he would return two ?sh a day during all of the next year. If someone accepted the offer, then the ?sh that Ms. Robinson or one of the others gave to Mr. Crusoe would constitute savings; these savings would be invested in the ?shnet; and the extra ?sh the net produced would constitute a return on the investment.
Obviously, the more productive Mr. Crusoe thought the new ?shnet would be, the more he could afford to offer potential investors for their savings. In this example, we assume that Mr. Crusoe thought he would be able to pay, and thus he offered, a 100 percent rate of return—he offered to give back two ?sh for every one he received. He might have tried to attract savings for less—for example, he might have decided to offer only 1.5 ?sh next year for every one he received this year, which would represent a 50 percent rate of return to potential savers.
Taken From : Five-Minute MBA – Corporate Finance
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