The paradigm of finance and financial activities revolves around money. The cost of money deals with that specific price or expense that has to be paid for the usage of money, whether it is in the form of a loan or possession. In other words, it is the opportunity cost or interest on a specific amount of money that is borrowed from some sources (Masodian et al., 2019). For example, multiple corporations use money and bear costs in terms of specific interest rates defined by the stakeholders. Such paid interest on borrowed amounts is the cost of money in the case of corporations.
Components Affecting the Cost of Money:
Four fundamental components have a grim impact on the cost of money. These include investment opportunities, time preferences for consumption, risk and inflation.
Investment Opportunities:
The most significant factor in this regard is investment opportunities. The interest rate or cost of money directly depends upon the investment opportunities in business profitability. In this context, higher profitability urges high costs of money to lenders by the business units and vice versa (Gapenski, 2022).
Time Preferences for Consumption:
The cost of money or interest rate has foundations in time preferences for debt consumption. In this aspect, the lender’s final decision to fix the interest rate may be high or low, depending on time preferences. For example, a lender may reduce interest rates if he has a long-term future preference for consuming a specific amount by the borrower.
Risk:
Another important component in this regard is the risk. The ease of paying the cost of money by an investor highly depends upon the risk factor in any business. In high-risk business models, investors are reluctant to pay a high interest rate on the borrowed amount.
Inflation:
Furthermore, inflation plays a greater role in determining the interest rate on the borrowed amount. Inflation is also considered unpredictable in future. However, with the help of various indicators, lenders will have an idea about inflation in the future. So, if the inflation rate is predicted or estimated to be high in the future, the interest rate will be highly fixed by the lender.
Long-Term Debt:
A debt is considered a long-term debt if it acquires maturity spanning more than one year. Long-term debts can have dual options in this regard, either a personal long-term debt or concern for various businesses or corporations.
Types of Long-Term Debt Financing:
There are several types of long-term debt financing, including long-term loans, bonds, mortgage bonds, debentures, etc.
Long-Term Loans:
A long-term loan is basically a contract between a borrower and a lender over the principal payment amount. The borrower has to pay interest in series and the principal money to the lender on prescribed dates. In other words, the contract spanned a long duration of time, during which the investor or borrower paid back all the money and interest in multiple instalments. The duration of such a loan is decided by both parties, and it usually lasts even for several years according to specified terms and conditions of the contract (Gapenski, 2022).
Bonds:
Bonds are also related to contracts like long-term loans where the borrower and lender have a contract regarding interest and amount of payment in the form of a bond. One main difference between bonds and loans lies in that bonds are generally registered with the SEC.
Debenture:
A debenture is considered an unsecured bond, having no security in the form of any specific property for any obligation. Their usage and application depend upon the nature of firms, and usually, debenture holders are creditors secured by the non-pledged property.
Usage of these Tools as a Manager:
These tools can be used to frame long-term investment opportunities as a manager. Similarly, these tools can allocate resources according to the need for time and space in alliance with amplified flexibility. In addition, as a manager, these tools can contribute to good decision-making regarding various changes in business platforms like interest rates, market ups and downs, economic circumstances, etc. (Matemilola et al., 2018).
References
Gapenski, L. C. (2022). Healthcare finance: An introduction to accounting and financial management.
Masodian, A., JAFARI, S. A., Erfani, A., & Abunori, E. (2019). An Analysis of Calculating the Cost of Money in Iranian Banks (Case Study: Sepah Bank Branches in Semnan Province).
Matemilola, B. T., Bany-Ariffin, A. N., Azman-Saini, W. N. W., & Nassir, A. M. (2018). Does top managers’ experience affect firms’ capital structure?. Research in International Business and Finance, 45, 488-498.
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