Sunil Jain: Capital News

Since this is going to be difficult to believe, it’s best to quote directly from the McKinsey Quarterly’s latest study on the impact of the current crisis on the long-term cost of capital: “Despite the decline in equity values and the increasing spreads on corporate debt, there is no evidence of a substantial increase in the cost of long-term capital.” (http://www.mckinseyquarterly.com/PDFDownload.aspx?L2=3&L3=40&ar=2269). McKinsey first examines the long-term relationship between GDP growth, corporate profits and share prices. In mid-2008, it estimated, the long-term sustainable level of corporate earnings would suggest an S&P 500 of around 1,100-1,200 — it was around 15-25 per cent below this at the time of the study. After taking into account the impact of GDP growth and corporate profits, McKinsey puts together a matrix on stock earnings and share prices (see graphic).

So, for instance, a 20 per cent fall in share prices, if combined with a 7.5 per cent decline in profits adds up to 0.6 per cent hike in the cost of equity capital, a figure that is ‘within the range of annual market fluctuations’. What of debt, especially since the spreads between corporate paper and US T-bills have risen? According to McKinsey, only in six of the last 20 years, has the yield-to-maturity on A-rated bonds been lower than what it is now, and the spread is rising because there is a huge demand for T-bonds right now — the low rates of the past were unsustainable and this is probably a reversion to mean. It would be interesting to see what a similar study for India would throw up.