ISSN 1822-6515 EKONOMIKA IR VADYBA: 2011.

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THE COST OF CAPITAL IN THE PRESENT-DAY CONDITION: THE IMPACT OF THE GLOBAL FINANCIAL CRISIS
Mokhova Natalia
Brno University of Technology, Czech Republic, mokhova@fbm.vutbr.cz

Abstract
The Global Financial crisis of 2008 provides great recession and leads a company to the stage of crisis in case of blocking the provision of capital to business long enough to generate failures. Thus one of the most important parts of post-crisis financial management is to define the impact of the crisis on the cost of capital, determinate factors that have influence on the cost of capital and how they have changed due to the financial crisis and by the means of that knowledge make the optimal financial decision to develop a company. The object of this article is the cost of capital and the changes of external and internal factors influencing on it due to the world financial crisis. Those relations are conductive to optimal financial strategy of a company to get out of crisis period and move to the stage of growth. But the impact of external factors is very high and in distinction of internal factors a company cannot manage them. Thus the determination of their influence on the basic financial parameters is essential for stable development of a company. Keywords: cost of capital, financial crisis, loan capital, equity capital, impact. JEL Classification: G31, G32, G34, G01.

Introduction
According to the global financial crisis of 2008 a lot of changes have happened in all spheres of economy. The impact of basic factors on the cost of capital was changed because the conditions of the environment were changed. That in turn has an effect on the behavior of investors. The loan capital became the cheapest source of capital and the equity capital is too expensive for the enterprises nowadays, at the same time the availability of different sources of capital changed. So the firm should act in different way and create new financial strategy and as a result the strategy of development. Thus in the adjustment process we have to find new way to optimize the structure of capital with less expenses, new methods of decreasing the cost of capital and new sources of capital. The analysis of the influence of financial crisis on the cost of capital will help companies to go out of crisis and move to another stage of growth. There are several external and internal factors, which have a great impact on the cost of capital. But due to the financial crisis some of them became more sufficient and their adjustment is one of the elements of crisis management. The new optimal and effective financial strategy based on the relations between cost of capital and factors influencing it according to the changes caused by financial crisis have to include capital, time and risk management.

The financial crisis influence an enterprise and its environment

Financial crisis that broke out in 2008 has had a big influence on the world economy. The consequences of financial crisis were across-the-board. A lot of companies were close to the bankruptcy, financial performances hardly decreased. There are several the most important consequences of financial crisis according to the cost of capital: lower return of investment, less liquidity, reevaluation of risks, difficulty to find long-term loans and another financial resource, higher spreads, new gearing and need of state guarantee. In the most countries inflation decreased, that in turn leads to lower interest rates and as a result decreasing cost of capital. But in some countries with tight monitory policy the refinancing rate and inflation have increased. Thus that consequent effect is ambivalent. In order to manage equity capital effective in the crisis not only consequences have to be taken into account but also its causes and what is more it is essential to find out the lessons from them. The lack of information is one of those causes. Thus information availability, information quality and financial disclosure are factors that have great impact on the cost of capital during the crisis and post-crisis period. Stronger financial disclosure decreases the information asymmetry and reinforces investments confidence. That in turn reduces systematic risk and leads to lower cost of capital. Greater financial disclosure also reduces the cost by increasing the stock market liquidity (Ceng and Collins, 2006). The

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companies should increase transparent disclosure policy that in turn decline agency and estimation risks and as a result decrease cost of equity capital. The next problem is the ignorance of the regulators authorities. They didnt keep up with the times in the sphere of financial innovation. Also there should be more external and internal regulating and auditing as higher auditing quality leads to lower risks and as a result decreases cost of equity capital. Wrong risks evaluation caused crisis. First of all because market was oriented on the financial service segment and companies with high leverage. The crisis was reflected in new models of evaluation considering estimation, liquidity, agency, market, interrelation and operational risks and new optimal structure of capital. Differences between investors and mangers interest play great role in the equity capital management and can be cause of the crisis. Shareholders have to control mangers and stimulate them on the long-term growth of the company. Shareholder rights should be stronger because that leads to lower cost of equity capital. There are some external factors that cannot be forecasted and managed: confidence of customers, firms and investors, global imbalance, government policy (financial regulations and monitory policy). Imprecise monitory policy was one of the most considerable factors that caused the financial crisis. It drove the rapid rise of house prices, led to mortgage defaults and so led to the over-pricing of mortgage-backed securities. And large account surpluses in emerging financial markets led to large financial flows that drove down the interest rates in the US and other developed countries. In addition decline in saving rate led to innovative more complex financial products with high returns that caused financial collapse. But there exists opinion that financial crisis hasnt influenced on the cost of capital (Dobbs, 2009). Research shows that the long-term price of risk hasnt increased over its historical levels and during present financial crisis the cost of capital was remarkably stable. But this research doesnt take into account risk influence that affect on the cost of equity capital. And also it doesnt concern to the firms that on the stage of crisis or post-crisis period in the context of life cycle of enterprise first of all because they dont have access to new capital. Companies have to be careful in the management of capital during the crisis because interest rates are low now, but in the future they can rise and if the companys return will stay at the same low level its financial stability decrease and the company can be close to the bankruptcy. The current economic environment occurred changes in the influence on the cost of capital.

The impact of global financial crisis on debt capital

Several leverage-driven bubbles - the mortgage-bubble and bubble in corporate earnings - preceded the present financial crisis. The total eventual credit losses in most economies led to the world recession. Such shocks and subsequent downturns have impact on the availability of credit and as a result on the cost of debt capital. In many cases the period of financial recovery depends on governments bailout package in order to repair the banking systems ability to provide credit efficiency, restore confidence between companies and investors and increase economic growth. One of the measures directed at financial recovery is tax advantages providing by government. Firms will use an additional tax shield that in turn will decrease the cost of debt capital. By the globalization of world economy and bank system at the period of low interest rates and risk spreads, the share of debt grew rapidly since 2000 in most developed economics. By 2008 several countries as United Kingdom, Spain, South Korea and France had higher levels of debt as a percentage of GDP than the United States (McKinsey & Company, 2010). This fact can be explained by low interest rates and tendency to finance investment with debt. Instability of financial system blocked the activity of financial institutions and investment funds on the credit market and led to the lack of liquidity that made difficult of long-term capital formation. One of the most significant causes of credit crisis was the tendency to finance long-term illiquid assets with short-term debt. After the crisis borrows do not have enough cash to repay the short-term debt and as a result sell their illiquid assets, but as the supply of such assets is too big, the prices are decreasing. In the past 30 years there were at least six financial crisis caused by companies and banks were financing illiquid assets with shortterm debt (Koller, 2010). In the result cost of debt capital decreased. So nowadays one of the challenges of government and CFOs is debt reduction on the macro and micro levels. The crisis has shown that common equity was the only form of capital that absorbed losses. This is

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one of the indirect reasons why equity capital was raised by crisis. Thus deleverage is a financial tool to improve the quality of capital in order to go out of crisis. Before financial crisis there were three decades in which capital were cheap and more available. The long fall in interest rates caused the global credit bubble. But low-interest-rate environment is going to the end because of long-term trends in global saving and investment that contributed to low rates will reverse soon after the crisis. The desire to invest will exceed the willingness to save, pushing real interest rates up. The redundancy of global saving increased the capital supply in excess of the demand for capital to invest that in turn pushed down cost of capital (McKinsey Global Institute, 2010). But the global crisis influenced the changes of global saving/investment ratio raising investment demand and lifting cost of capital next years. That tendency is caused by companies pursuit to go out crisis and be found on the stage of growth, consequently production is modernized demanded new investments. The growing imbalance between the supply of savings and the demand for investment capital will be significant by 2020. And real long-term rates such as real yield on a ten-year bond can start rising even within the next five years that show increasing of capitals cost both debt and equity (Dobbs, 2010). During the global financial crisis of 2008 a lot of companies faced with many difficulties. But one of the most important consequences was credit constraint. Companies that were very affected after crisis found that they experienced less access to credit (81%), higher cost of funds experienced 59% of very affected firms and 55% found difficult to access a credit line. Not very affected companies suggested that they had fewer difficulties on the credit market. So only 50% experienced quantity constraints (less access to credit), 40% thought the cost of capital is too high and 20% found difficulties with lines of credit. (Campello, Graham and Harvey, 2010). Thus the credit crisis had more influence the availability of credit source then its cost. The firms faced with the global financial crisis and limitations of credit market are likely to use equity source of financing. But the cost of equity capital is much higher in good economic times, so during recession it rapidly raises.

The impact of global financial crisis on equity capital

The situation on the equity markets also was hazardous and unstable that indicates the gravity of financial crisis. At the end of October 2008, the S&P 500 index had fallen by 46 percent comparative to previous year (McKinsey & Company, 2008). The fall of financial markets led to decreasing of companies stocks therefore their market capitalization. Those facts and rapidly increasing risks caused by instability lead to higher cost of capital. Risk-premium is the key element in thee estimation of the cost of equity capital. It represents the additional compensation investors require for assuming the additional risk and compensation for unexpected increasing of inflation. As risk-premium varies with time, depending on the information available at the moment, financial crisis had a great impact on it. Different effects are influencing on its value: price effect, risk effect, risk aversion effect, market effect. Financial market instability has risen risk-premium and as a result the cost of equity capital. First of all it has happened because of increasing systematic risk and reduction of investors confidence. In most mature economies risk-premium raised during crisis. From 2007 till 2008 Germany risk-premium increased from 6,94% to 8,14%, in France this indicator raise from 7,26% to 8,74% , the average index of risk-premium in Europe grew from 6,20% to 7,96%. USA index also grew from 6,04% to 7, 12%. The growth of risk-premium is shown in Figure 1. As we can see the growth of risk-premium in most countries was substantial, that had a great influence on the cost of capital. The less growth of risk-premium so as a result cost of capital was in USA. The central Europe had also rapid growth (German 17,4%, France 20,33%). But the average risk-premium growth on the EU market was much higher 28%. According to world financial system including developed and emerging markets risk-premium increased from 5,81% to 8,33% with growth of 43,54% (Arouri, Javadi & Foulquier, 2009).

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Figure 1. The risk-premium growth during 2007 2008 The risk premium could be rising today also if central banks increase the money supply in order to stimulate economic growth after the crisis, creating investors uncertainty about future inflation.

Conslusion
The global financial crisis had great influence on the cost of capital. Significance of external and internal factors that have impact on cost of debt and equity capital transformed and led to changes in capital valuation. The global fianncial crisis initiated additional risks on the fianncial markets and reinforce existent that in turn increase coct of capital. Thus comapnies have to create new effective system of risk management and new methods of liquidity risk evaluation. This article will help companies to create optimal and reasonable financial strategy in order to recover the financial stability of a company and move to the stage of growth. Also the understanding of the influence of factors on the cost of capital due to the crisis leads to rational financial decisions and as a result successful development. And as u result due to the new financial strategy a company manage to restore confidence among stakeholders (consumers, investors, lenders and other companies) If capital costs increase firms with higher capital productivity will have more flexible strategy and competitive advantages. But the firms that relied on cheap capital during the time of long-term interest rates increasing will reduce their profitability.

References
1. 2. 3. 4. 5. 6. 7. 8. 9. Arouri, M. H, Jawadi, F. & Foulquier, P. (2009). Impact de la crise sur le cot du capital: une comparaison internasionale de lvolution de la prime. Journal Gestion 2000, 26(6), 51-62. Campello, M., Graham, J.R., Harvey, C. R. (2010). The real effects of financial constraints: Evidence from financial crisis. Journal of financial Economics, 97, 470 487. Ceng, A., Collins, D. & Huang, H. (2006). Shareholder rights, financial disclosure and the cost of equity capital. Review of Quantitative Finance and Accounting, 27, 175-204. Cogman, D., & Dobbs, R. (2008, December). Financial crises, past and present. The McKinsey Quarterly. Retrieved from: http://www.mckinsey.com Dobbs, R., Lund, R. & Schreiner, A. (2010, December). How the growth of emerging markets will strain global finance. The McKinsey Quarterly. Retrieved from: http://www.mckinsey.com Koller, T. M. (2010, April). Why value value? defending against crises. McKinsey Quarterly. Retrieved from: http://www.mckinsey.com Martin, C. & Milas, C. (2010). Financial market liquidity and financial crisis: an assessment using UK data. International Finance, 13 (3), 443-459. McKinsey Global Institute (2010, January). Debt and deleveraging: The global credit bubble and its economic consequences. Retrieved from: http://www.mckinsey.com McKinsey Global Institute (2010, December). Farewell to cheap capital? The implications of long-term shifts in global investment and saving. Retrieved from: http://www.mckinsey.com

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