Money, Money Everywhere

Thanks to a bull market, capital costs are at a 40-year low

Today is heaven for corporations looking to raise money--whether an Internet startup doing an initial public offering or an old-line manufacturer issuing bonds to finance a new factory. According to a study by the University of Pennsylvania's Albert Ando and two other economists published in January by the National Bureau of Economic Research, the average cost of equity and debt is at or near its lowest point of the last 40 years. "Nothing looks bad," says Jean Helwege, a senior economist at the Federal Reserve Bank of New York. "I can't see a single market where you'd say, `Oh, God, it's a terrible place to raise funds."'

The cost of capital can be critical to whether an economy succeeds or fails. Simply speaking, it's how much companies have to pay for the use of money.

IPO BOOM. In the debt market, the cost of capital is the rate of interest, adjusted for inflation. In the equity market, it's similar--the profit that a company is expected to produce on each dollar invested in its stock. That's the earnings-price ratio, the flip side of the better known price-earnings ratio. Thanks to the bull market, the price-earnings ratio has soared and its inverse, the earnings-price ratio, has plummeted. For the Standard & Poor's 500-stock index, it fell by nearly 2 percentage points, from 8% in the late 1980s, to 6.1% in 1995-96 (chart). Today it's under 5%.

Of course, cheap capital is worthless if companies decide there's nothing to spend it on. That's the situation in Japan, where some real interest rates are actually negative and earnings-price ratios are microscopic, yet investment remains sluggish. In the U.S., by contrast, lots of companies are taking advantage of the financial markets' strength to raise money inexpensively. Securities Data Co., a unit of Thomson Financial Services, calculates that the amount of new debt issued in 1996 set a record of $300 billion, while the amount of new stock hit a record $115 billion.

Much of the stock issued last year was in initial public offerings in high technology. "The last 18 months have simply been the best time for young technology companies to raise equity capital," says James W. Breyer, managing partner of Accel Partners, a San Francisco venture-capital firm. As for debt, companies such as Walt Disney, J.C. Penney, and ibm are breaking tradition by issuing 100-year bonds. Others are refinancing existing debt at lower rates. Toro Co. is paying 8% on most of its long-term debt, down from 11% or so before a series of refinancings over the last two years, says Gerald T. Knight, cfo of the Bloomington (Minn.) lawn mower maker.

That's not to say that Corporate America on the whole is on a binge of selling stocks and bonds. Most companies don't need to. With profits so strong, they can finance their investments through retained earnings. That degree of self-reliance somewhat diminishes the impact of cheaper capital on corporate behavior, says William Lewis, the partner in charge of McKinsey & Co.'s McKinsey Global Institute in Washington, D.C.

While both equity and debt capital have gotten cheaper, the biggest drop has come on the equity side. Go back to 1988-89, when the economy was at a similar point in the business cycle, as measured by the unemployment rate. Back then, equity was about 3.6 percentage points more costly than debt. That's gauged by comparing the earnings-price ratio of the s&p 500 at about 8% with the real interest rate on 10-year Treasury bonds at about 4.4% (charts). The gap has since narrowed to about 2.4 percentage points.

The result is that cfos are leaning much more toward equity than they did in the late 1980s. True, a number of companies are buying back their shares in hope of boosting stock prices--as Philip Morris Cos. is doing under a three-year, $8 billion buyback announced Feb. 26. The wave of mergers, too, is tending to extinguish equity as companies disappear.

But these trends toward reducing equity were much stronger in the late 1980s, when mergers and leveraged buyouts wiped out huge swaths of equity. Today, companies are still retiring equity on the whole--but they are doing so at a much slower pace than in the 1980s.

HURDLE RATES. Today's lower cost of capital is stimulating corporate investment--but only to a degree. In theory, the availability of cheaper capital should encourage companies to lower the "hurdle rate" that they use to judge whether projects are worth investing in. In practice, though, hurdle rates don't change as quickly as prices of stocks and bonds.


Toro is typical. When the company found itself with excess cash in 1995 and 1996, it used the money to repurchase shares because it couldn't find any appropriate acquisitions or internal projects that met its pre-established target for return on investment. "We don't make major adjustments within a three-year cycle," says Toro's Knight. Likewise, Pitney Bowes Inc. is buying back 9.2 million shares over the next two years because executives don't see any "must" investments that aren't already funded.

Still, for fast-growing companies that do need to raise money--and there are thousands of them--today's lower cost of capital is manna from above.