What is the cost of capital? How does it affect the required return and investment of companies? originally appeared on Quora, the place to gain and share knowledge, empowering people to learn from others and better understand the world.

If you are a business owner or have considered being one, you may be familiar with the concept of the cost of capital. However, how the cost of capital affects your company's investment decisions is not obvious.

The cost of capital refers to the return that investors expect to receive in exchange for providing money to a company. It's influenced by factors like interest rates and the state of the financial market.

It's commonly assumed that a lower cost of capital leads to higher investment rates among companies. The logic is: if we lower the cost of capital, companies find it easier to make a profit on their investment projects. They therefore apply a softer threshold to evaluate projects, which is to say the “required return” of companies should fall and investment should rise. Every management and economics textbook recommends that companies should apply this simple logic. This idea also shapes the actions of policymakers, especially central banks’ decisions about interest rates. But unfortunately this simple idea is incomplete.

New research shows that while the cost of capital has decreased significantly over the past two decades, companies haven't increased their investment levels. So, what's behind this disconnect? It turns out that the traditional model of the cost of capital doesn't quite capture the real-world behavior of companies.

To better understand investment decisions, researchers have been exploring how companies actually behave when the cost of capital changes. Here is some of my work on this topic. One key insight is that companies often don't adjust their required returns in tandem with the cost of capital. Instead, they tend to maintain a relatively stable required return, even as market conditions change. This means that when the cost of capital drops, most companies don't become more willing to invest. They are still cautious about committing resources to new projects, possibly because they worry about seeming like reckless spenders or because they worry about future downturns.

Here is a figure showing the share of firms that have maintained an unchanged required return (also known as discount rate) over the given number of years (on the horizontal axis). Ten years after the first observation, 40 percent of firms have an unchanged discount rate. In contrast, only 5 percent of firms have not changed their internal estimate of their cost of capital after ten years.

Simply put: the relationship between the cost of capital and investment is more complex than we used to think. As a result, investment and firm dynamics in recent decades have been much more sluggish than we would have expected.

This question originally appeared on Quora.

Photo Credit: Image Credit/Unsplash