Bond and equity markets (public or private) are important for employment creation. The growth in gross fixed capital formation is the fuel that keeps the economic engine running.
Robust economic growth is imperative for sustainable employment creation. And over the years, there’s been ample academic literature that proves the existence of a positive relationship between capital formation and economic growth. But which asset class has the biggest impact on job creation?
Ultimately, the answer to this question is two-fold. One needs to address the question of optimal capital structure, and how efficiently corporations deploy capital within an economy.
Broadly speaking, companies have two choices when it comes to the financing of investment projects. They can either borrow money or use shareholder capital. The different sources of financing have their advantages and disadvantages.
The challenge here would be to find an optimal mix of debt and equity in order to minimise overall cost of capital. This would lower the hurdle rate of return required from investment initiatives for them to be attractive and, by extension, allow companies to take on more investment projects which will benefit economic growth.
Looking into the characteristics of the different sources of financing, debt offers the lowest cost of capital due to the tax deductibility of interest payments. However, this comes with contractual obligations to make periodic payments to service the debt. This means that too much leverage increases the financial risk to shareholders and the return they require when providing equity capital. On the other hand, equity financing is expensive. On a relative basis, an equity investment is way riskier than an investment in debt securities. As such, shareholders require a return that fully reflects the riskiness of the investment. Therefore, companies seeking financing for new projects need to find the optimal point at which the marginal benefit of debt equals the marginal cost.
Esta historia es de la edición 9 May 2019 de Finweek English.
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Esta historia es de la edición 9 May 2019 de Finweek English.
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