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Internally generated (pay bills later and encourage speedier payment from customers)
Furthermore, the cost-of-capital interest rate a company experiences is affected by the risk associated with its business type. The market perceives the risk of the business and applies an after-tax discount rate to the future wealth it expects to derive from the firm. Consequently, the rate banks charge for borrowed funds cannot be taken alone as the company’s cost- of-capital interest rate when evaluating investment alternatives. For a complete treatment of cost-of-capital see Modigliani and Miller’s classic paper “The Cost of Capital, Corporate Finance and the Theory of Investment” published in The American Economic Review.
Many discussions of equipment economics include interest as a cost of ownership. Sometimes the authors make comparisons with the interest rates that banks charge for borrowed funds or with the rate that could be earned if the funds were invested elsewhere. Such comparisons imply that these are appropriate rates to use in an equipment cost analysis. A more thoughtful analysis yields the proper character of the interest rate a company experiences. A company requires capital funds for all of its operations. Hence, it is not logical to assign different interest costs to machines purchased wholly with retained earnings (cash) as opposed to those purchased with borrowed funds. A single interest rate should be determined by examination of the combined costs associated with all sources of capital funds: debt, equity, and retained earnings.
There are two parts to the common misunderstanding concerning the proper way to account for interest. First, as just discussed, the correct interest rate should reflect the combined effect of the costs associated with all capital funds. The second error comes in trying to recoup interest costs. Interest is not a cost to be added together with purchase expense, taxes, and insurance when calculating the total cost of a machine.
This might be easier to understand using an analogy. Consider the situation of a bank trying to decide whether a loan should be granted. The question before the bank is one of risk: what are the chances the money will be repaid? Based on the perceived risk, a decision is made on how much return must be received to balance the risk. If 100 loans are made, the banker knows some will not be repaid. Those borrowers who repay their loans as promised have to provide the total profit margin for the bank. The good loans must carry the bad loans. A company utilizing equipment should be making a similar analysis every time a decision is made to invest in a piece of equipment.
Based on the risk associated with the type of work the company will undertake, interest is the fulcrum for determining whether the value a machine will create for the company is sufficient. A proper interest rate ensures there is a gain in value compared to cost and risk.
The interest rate at issue is referred to in the economic literature as the cost of capital to the company, and a market value technique has been developed for its calculation. A complete development of the market value cost-of-capital calculation is beyond the scope of this text, but Reference 4 (Lewellen 1976) at the end of this chapter provides a good presentation of the subject. The resulting cost-of-capital rate is the correct interest rate to use in economic analyses of equipment decisions.