The Impact Of Interest Rates On Capital Allocation

Interest rates were almost zero for the previous ten years, capital flowed easily, and corporate leaders lined up to finance visionary projects. However, times have changed. In 2022, Fed raised the interest rates 7 times, leading to the matter of how to allocate capital effectively. The market is in freefall, companies are facing recession. Leaders will ask themselves “If that is the case, what is the plan for our capital commitments for next year in case things go south?”

How does interest rate impact the capital allocation decisions?

How does interest rate impact the capital allocation decisions?

It's crucial to realize that the weighted average cost of capital (WACC) is what a corporation would use to assess its capital allocation decisions. That sum represents the average cost of debt and equity financing, as its name suggests. Therefore, the cost of debt rises as interest rates do. However, lower projected equity returns (and hence lower risk premium) result in a reduced cost of equity capital. Additionally, each company's version of this equation will vary based on a variety of variables, including credit standing and future business opportunities. As a result, it is advisable to assess the cost of capital for each individual company.

What are the impacts of WACC on a company's capital allocation decisions, then? A corporation should invest in internal projects or take part in mergers and acquisitions, if doing so will increase its return on invested capital (ROIC) above its write-off against capital (WACC). The remaining free cash should be used to reduce debt, pay cash dividends to shareholders, and purchase back shares. The barrier to reinvestment rises with greater cost of capital. So, generally speaking, given a greater cost of capital, businesses might be less hesitant to invest in particular projects.

A company's ability to maintain a lower cost of capital than its competitors, however, is an indication of how little risk the market has associated with that company's line of work, organizational setup, or location. The ROIC, on the other hand, is frequently more significant than the cost of capital (or ROE for certain financials). Despite an increase in the cost of capital, businesses that can regularly produce a high ROIC can continue to provide value for shareholders and would continue to direct capital into such uses of cash. An organization with a consistently high return on capital either has strong pricing power, a low-cost production model, or both. In a somewhat circular fashion, there is a good likelihood that over time, a greater ROIC will result in a lower WACC.

In conclusion, the lower the cost of capital, the better, but a greater cost of capital would not materially alter how any company allocates its resources.

Interest rates have a big impact on corporate capital allocation decisions

How to allocate capital when interest rates are high?

Unwise capital allocation can, in fact, lead to severe outcomes like business failures, bankruptcies, layoffs, and write-offs. Once mistakes are made, getting back on track can be challenging. However, there is one suggestion that can assist with both the healing process and averting regrets in the future: think about incorporating more value-oriented thinking into capital allocation decisions.

How to allocate your capital wisely? In the article “Allocating capital when interest rates are high” of Harvard Business Review, the author mentions the “moonshot” approach. The “moonshot” approach is a mode of thinking, which is most famously associated with investors from the Benjamin Graham school, and is very useful to businesses. When interest rate hikes, it offers a broad, logical, and disciplined framework for all capital allocation. However, due to a decade of unrestrained risk taking, it is also one that is hard to find in organizations today.

Here are 5 values of capital allocation and the “moonshot” approach for each value:

1. Risk vs. Returns

• Value - Risk first: Question #1 "How can things go terribly wrong?", then "Are we protected against irreversible, game-ending losses if that happens?".
• Moonshot - Returns first: Question #1 "How can everything go amazingly right?", then "Are we set up to win big if that happens?".

2. Caution vs. Vision

• Value - Margin of safety: Spend money only when a fair analysis that includes some margin for error and doesn't rely on heroic assumptions clearly justifies it.
• Moonshot - Power of vision: Become dedicated to an idea that will change the game and has a lot of possibilities in the future. If one can carry out such a vision, today's presumptions and analysis won't matter as much.

3. Wisdom of the Crowd

• Value - Ignore the crowd: Avoid the urge to follow any business trends that may be popular at any given time. Have the guts to go against the grain and, when necessary, choose the opposite course from what other people seem to be doing.
• Moonshot - Evangelize the crowd: To persuade others to embrace the grand vision, cultivate excitement, faith, and "fear of losing out." Motivate the herd to follow our example and run with us.

4. Reality vs. Dreams

• Value - Separate dreams from reality: Pay special attention to unbiased, logical analyses of unit economics and capital efficiency. Do the calculations show that the cost of the capital required is comfortably greater than the return on invested capital? Prioritize scale and growth only after that.
• Moonshot - Make dreams real: Concentrate on determining what it will take to get over obstacles, expand swiftly, and dominate the industry. If we don't yet know how, trust that unit economics and capital efficiency will work themselves out along the road.

5. Timing

• Value - Patience: Avoid the urge to always be “doing something.” As you wait for the right moments to present themselves, feel at ease operating at relatively modest intensity levels for extended periods of time.
• Moonshot - Now or never: Time is precious, so stop wasting it. The dream must be realized via continuous effort, experimentation, and high-intensity activity.

Making right decisions on capital allocation to grow your business

However, it appears that this “moonshot” approach is too positive. Company capital allocation choices have grown so dominated by it over the past ten years that they are increasingly disconnected from reality. Even businesses with flawlessly sound, long-lasting business models have come to believe that they will fall behind unless they quickly "all-in" on some disruptive future vision (e.g., involving AI, crypto blockchains, virtual worlds, the cloud, space exploration, and so on). All of this has led to a frantic dash among competitors to develop and/or acquire assets, resources, and talent in these fields, seemingly at any cost.

Of course, certain industries will fare better in a climate with rising interest rates than others, for example, the finance sector. Bank loan interest rates will increase more quickly than the interest rates they pay on deposits in an environment where interest rates are rising. Wider spreads, also known as interest rate margin, result from rising rates. This results in greater profit. All parties involved in the market, including traditional banks, insurance providers, capital market organizations, and brokerages, would benefit from this.

To avoid bad decisions on capital allocation, companies should find more value-oriented thinkers in the decision-making teams that choose which projects to undertake. Finding a professional business consultant is advisable. Considering that they can offer a vital balance that keeps your capital commitments wise and grounded in reality. By doing this, you can not only assist your company in addressing the urgent economic realities of the present but also avoid repeating past mistakes.