During the recent financial crisis, blame has been placed on
corporations for a lack of new investments. While corporate cash
balances have been climbing, new investments have stalled. One reason
may be an increasing equity risk premium, or market risk premium (MRP),
as we call it in the text. An increase in the MRP premium increases the
cost of capital for any project, making the NPV less favorable. A recent
article in CFO argues that an increase in the MRP is a factor
behind the slowdown in capital investments. This may be part of the
problem, but we would like you to consider a couple of things.
While
the MRP may have increased, the cost of debt has decreased, so the
overall cost of capital could have remained the same, or even
decreased. As the article points out, calculating the MRP is not an
exact science. An increase in the MRP may be a factor, but the impact is unknown
at this time.
While we hope your education is teaching
you to critically examine arguments you hear or read, we would also
like to point out a glaring error in the logic of the argument presented
in this article. The article states that "stock investors are
questioning the very integrity of the markets, and the perceived risk of
holding an equity portfolio has increased." One reason given for this is the Facebook IPO debacle. And while the
Facebook IPO problems may have affected investors' beliefs about risk
and market integrity, the Facebook IPO occurred about six weeks ago,
much too recently to have had any effect on the MRP during most of the
period in question. http://www3.cfo.com/blogs/banking-cap-markets/banking--capital-markets/2012/06/the-real-reason-companies-aren’t-investing
