Interest Rates analysis
Interest Rates analysis
1) Consumer financing for big-ticket items: Interest rates, in simple terms, is the cost of renting money. It is the cost of using the bank’s money for a given period (Tiffany & Peterson, 2005). Short-term rates apply one borrows money for period range of one month to two years. Long-term rates are applicable to loans that extend to a thirty-year home mortgage. Interest rates influence the various facets of the economy, from consumer spending to business expansion. The Federal Reserve sets the short-term interest rates. Consumers use credit cards in modern shopping, and, hence, short-term interest rates influence shopping habits. The higher the rates the harder (and expensive) it is for consumers to buy on credit. Corporate and government bond markets dictate long-term rates. These rates influence affordability of houses, cars, and other big-ticket items. Consumers often rely on long-term loans to finance these purchases because they are expensive.
2) The present and future values of annuities: A rise in interest rate decreases the present value factor, and, hence, the present value (PV) of annuities (Megginson & Smart, 2008). High interest rates imply that people would have to set a reduced amount of money aside, in the present, in order to earn a given amount in the future. The future value (FV) of annuities relates to its present value as determined by multiplying the present value by (1+ interest rate), raised to the number of years of investment (FV = PV (1 + i)n. This implies that, provided the present value, number of years, and interest rates calculation of future value finds a value equivalent to the present value. Therefore, rising interest rates reduces the value of both the present and the future annuities.
3) The NPV calculation: the calculation of net present value uses the firm’s cost of capital as an interest rate (Lasher, 2008). Firms invest (purchase capital goods) in order to increase their capital through future output and income. An evaluation of the future income generated by an investment occurs in relation to its present value. NPV is the amount of capital to invest at present interest rates, in order to obtain an equivalent amount of income in future. The formula is. High interest rate reduces Net Present Value of an investment.
Example: The present value of obtaining an income of $ 20,000 in a year’s time, given an interest rate of 5% is equivalent to $20,000/(1+0.05)^1, which gives $ 19,047.62. If the rates rise to 10%, for example, and other constants remain the same the calculation is equivalent to $20,000/(1+0.10)^1, which gives $18181.81. Calculation of the firm’s net present value uses present value of capital, interest rate, and number of years of investment. High interest rates lower the net present value of an investment project. In other words, high interest rates reduce the present value of an investment capital, hence, making it less profitable for an investor to invest in new capital. However, if the interest rates reduce, the opportunity cost of investing in new capital also reduces. The lower the interest rate, the higher the net present value of capital investment and the higher the profit from the new investment.
4) Weighted average cost of capital (WACC): WACC represents a combined cost of debt capital and equity (Megginson & Smart, 2008). Debt capital bears interest expense, while equity carries the opportunity cost of forgone capital gains to external investors. Cost of debt capital is equivalent to the domestic interest rate of a country. Firms use WACC to evaluate proposed projects in terms of financial feasibility. Other factors constant, if the interest rate rises, the weighted average cost of capital will also rise because its equity and debt capital components increase with an increase in interest rate.
5) Corporate earnings: Interest rate influences asset growth and accounting profitability of an investment (Lasher, 2008). Corporations, especially small business agencies, finance their business activities through borrowed money and may have their earning s reduced in several ways if the interest rate rises. High interest payments take away some business earning which may have a direct impact on profit. Firms are not able to borrow more as they would at a low interest level. Therefore, they are more likely to invest less and generate less income and, hence less profit. Reduced investment by firms reduces employment which has a negative impact on the general productivity of business organizations. If the short-term interest rates are low in relation to long-term interest rates, financial institutions including banks can invest excessively in long-term assets, for example, treasury bills. If interest rates increases unexpectedly, the value of such long-term investments falls, making financial institutions experience loss in significant measure. However, high interest rates increase profitability from investments in money markets.
References
Lasher, W. (2008). “Practical Financial Management”. Mason, OH: South-Western Cengage
Learning.
Megginson, W. & Smart, S. (2008). “Introduction to Corporate Finance”. Mason, OH: South-
Western Cengage Learning.
Tiffany, P. & Peterson, S. (2005). “Business Plans for Dummies (2nd ed.)”. Hoboken, NJ: Wiley
Publication, Inc.
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