Activity within the financial markets is important to corporations. The capital market is significant because it generally determines the cost of long-term financing. Which statement best describes this relationship?

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Capital markets establish the price investors require for long-term funds, so they drive the cost of long-term financing for a corporation. When a company issues long-term debt or equity, investors demand a return that reflects risk, time horizon, inflation, and liquidity. That required return becomes the cost of funds the company must pay to obtain financing. In short, market conditions for long-term securities set how expensive it is for the company to raise capital over a long horizon.

This isn’t about who determines asset values outright, since asset values depend on expected cash flows discounted at the appropriate rate. It also isn’t about daily trading volume or tax policy, which are driven by liquidity and government decisions, respectively.