How is the cost of capital determined? What impacts capital lending markets?
One of a business’s costs is its capital, which it usually borrows from capital lenders. This lending happens in a competitive market. In The Wealth of Nations, Adam Smith discusses three factors that influence that market: risk to the investor, profit on capital, and changes in supply chains.
Continue reading to learn how the markets determine the cost of capital, according to Smith.
The Cost of Capital
Smith identifies the cost of capital—all of the equipment, materials, and money (outside of wages and rent) required to run a business—as the third factor that influences the natural price of a good. He explains that capital is typically lent to businesses for a profit. Those who own a surplus of capital lend it out to interested businesses out of self-interest, and they’ll naturally expect a return on their investment. Therefore, the natural price of the good will include not only the cost of the capital itself but also the profit of the investor.
Capital is lent to businesses in a competitive capital lending market. When the supply of capital exceeds the demand, capital lenders will have to lower their profit margins to compete with each other. When the demand for capital exceeds the supply, businesses will compete with each other for investment and therefore capital lenders will be able to raise their profits.
(Shortform note: Economists support Smith’s assessment of competition in capital markets. The more lenders have to compete with each other, the lower the costs of borrowing capital for business. However, it’s important to consider that these markets can have a very different impact on businesses of different sizes. When capital markets aren’t competitive, the corresponding rise in costs squeezes small and medium-sized businesses out of the market, as only large companies can afford to borrow capital at the higher rates.)
Smith identifies three key factors that influence the markets for capital.
Factor #1: Risk to the Investor
The cost capital adds to the natural price will change from industry to industry depending on the risk to the investor. Smith states that, if a business venture has a significant chance of failure—for example, a ship getting lost at sea—then the investors will need a rate of profit on their capital sufficient to recoup potential losses. This will drive up the natural price of capital for goods whose production requires a risk of financial loss.
(Shortform note: Contemporary investment experts generally agree with Smith’s assessment of the relationship between risks and rewards. However, they caution investors against assuming that high-risk investments automatically offer high rewards. Instead, they recommend assessing the chance for risk and reward for each investment using historical precedent. Financial analysts measure the historical returns and losses on an investment and then measure the standard deviation to estimate its future potential for risk and reward.)
Factor #2: Profit on Capital
The cost of capital is also going to be influenced by the profit gained by the investor who lends out their capital. Smith states that capital lenders are also guided by their self-interest and invest to gain the most return. However, capital lenders are also competing with each other in a capital market—as such, their ability to profit will be determined by the ratio of supply (capital to lend) and demand (businesses borrowing capital).
Much like labor, the profits of capital are impacted by a nation’s overall economic growth. However, Smith explains that they have the exact inverse relationship: Strong economic growth results in lower profits on capital while slow economic growth results in higher profits. During high economic growth, the nation has an excess of circulating capital to invest. This will cause investors to lower their rates of profit in an effort to bid against each other. When economic growth is slow, there is less circulating capital to invest in businesses. This will mean that businesses will have to compete with each other for investors, driving up the profits they’re willing to hand over in exchange for capital.
(Shortform note: The need for businesses to compete with each other for investment can cross-pressure business leaders, as the demands of their shareholders may be in tension with those of their customers. For example, a company that reinvests profits in developing and marketing new products may have a competitive edge when competing with other businesses for customers. However, a company that pays those profits as a dividend to its shareholders will have a competitive edge in attracting capital. This has led some to worry that pressure from investors may lower the competitiveness of businesses in customer markets, which may be more important for a company’s long-term success.)
Factor #3: Changes in Supply Chains
Recall that capital includes all of the materials and equipment required to run a business. These materials and equipment are also goods that must be purchased at market value and follow their own ratio of supply and demand. Therefore, any change in the price of supplies or equipment will find its way into the natural price of goods. For example, a company making light bulbs would be impacted by changes to the price of glass, metal filaments, or argon gas.
(Shortform note: To insulate themselves from fluctuations in supply chains, many corporations have adopted a strategy of vertical integration. This occurs when a company buys up its suppliers so that it can generate supplies itself instead of buying them at market rate. For example, a company that makes leather belts might buy its own leather tanning factory, or even its own cattle farm, to vertically integrate its supply chain. However, business experts are mixed on the overall effectiveness of vertical integration. Some highlight the costs saved, while others emphasize the enormous cost of purchasing suppliers and contend that the costs outweigh the benefits.)