The rising cost of capital

Silvan Mifsud is director of Advisory at EMCS Tax & Advisory

For most of the last 15 years, capital has been cheap. Since the 2008/9 final crisis the cost of borrowing has been very low. All that changed last year, when the world’s central banks began raising interest rates to curb rising inflation. As seen below, whilst in previous years, a 10 year Malta government bond had a yield which was very low, sometimes even close to a 0% YTM (yield-to-maturity), by the end of 2022 a 10 year Malta Government bond was yielding a YTM of around 4%. With the sovereign Malta government bonds being considered almost risk free, corporate bonds need to be issued at higher rates, to cover the risk premium.

What does this mean for businesses?

As the cost of capital rises, companies need to re-assess how they should be allocating their resources. Here are some insights on this matter.

• Re-evaluate growth investments: We all know the obvious ways that growth can destroy value, like pursuing unprofitable business models or pushing products with negative gross margins. But profitable growth can destroy value too. This occurs when the capital that is invested in growth initiatives generates an accounting profit but does not produce a return on capital that exceeds the business’s cost of capital. This means that as the cost of capital rises, business leaders need to much more discerning about growth investments and make sure that they invest in projects that that are likely to produce substantially attractive returns.
• Invest in improving productivity: The main effect of rising interest rates is a slowing economy. Thus businesses need to find ways to increase productivity during slowdowns and not merely cut costs. Boosting productivity requires that business leaders identify the factors preventing their people from getting things done. In some instances, the problem is organisational complexity — that is a combination of complex processes, organisational structures, cultures and ways of working. Unless all these underlying factors are removed or otherwise dealt with it will be difficult to increase productivity which will translate in margin improvement. Moreover, enhancing productivity often requires investment, especially investment in technology. Some new technologies offer the potential to dramatically improve productivity, with modest investment. There is a growing business case study for AI-applications that can enable many routine tasks to be automated. If done right, technology investments reduce costs and increase productivity, allowing a company to improve margins in the short-term without sacrificing growth in the medium- to longer-term.

I hope the message is clear. The era of cheap money is over. In the face of rising capital costs, business leaders need to rethink their approach to resource allocation and capital planning. Once “obvious” investments in growth may need to be reconsidered. In the meantime a greater focus needs to be given on actions to improve margins through an increase in productivity. Capital — and its costs — must be measured and carefully managed. Not doing so, means that business risk over-investing in the wrong opportunities, at elevated costs and this undermining future profitability and value creation.