How do increases in market interest rates affect a firm's cost of capital?

When market interest rates rise, it leads to changes in both the cost of equity and the cost of debt.

For the cost of debt, when interest rates increase, new debt will generally need to be issued at these higher rates. This means that the interest expense a firm incurs on new borrowings increases, thus raising the overall cost of debt. Existing debt might have fixed rates, but as new financing is needed or as firms refinance, they will face the higher prevailing rates.

Regarding the cost of equity, rising interest rates typically lead to an increase in the required return by equity investors. This is because higher interest rates signal a higher opportunity cost of capital—investors expect a higher return when they could alternatively invest in safer, interest-bearing securities. Consequently, firms must offer investors greater returns on their equity to attract investment, effectively increasing the cost of equity.

As both the cost of equity and cost of debt increase during periods of rising interest rates, the overall cost of capital—the average rate that a company must pay to finance its assets—also rises. This concept underscores the sensitivity of a firm's financial structure to shifts in the broader economic environment, particularly interest rates.