Table of Contents
Monetary policy aims to affect the behavior of investors and borrowers through the interest rate instrument. Money market complies with the general economic law of demand and supply where the interest rate appears to be the price. Central Bank uses interest rate to influence the exchange rate and the price level at the country. Increasing rates are the sign of restriction monetary policy, while decreasing interest rate leads to the economic liberalization and rise. The main reasons for Central Bank to raise the interest rate may be the high inflation and the attraction of capital inflow to the country.
Consumer Financing for Big-Ticket Items Such as Autos and Homes
Taking into consideration the economic background of high inflation triggered by the global economic factors, the rise of interest rates will cause the shrink in aggregate demand. The markets of expensive and large commodities, like vehicles, houses, and other appliances of the households, will be first to decrease due to the fact that households, as a rule, use financing for such purchases.
The affordability of a loan, lowered by the interest rate increase, causes the decrease of money supply available currently for an average person and therefore they buy less. On the other hand, people start saving more, since the possible gain from financial funds rose along with the interest rate. Another effect of such restriction would be the prevention of housing and car prices from further rise. Therefore, the Federal Reserve System limits the amount of money in the economy, by locking them in financial institutions in a form of either savings or lower loans issuance.
Interest Rate and the Present and Future Values of Annuities
The interest rate is the key element in estimation of future cash flows. Since the estimation lies in discounting, the interest rate that is expected to rise over time leads to expectation of lowering value of future cash flows. Investors assess their assets and the concept of "money in time" influences the structure of their holdings.
In the short-term perspective high interest rate bring benefit to firms that have financial assets as their interest income is expected to increase. On the other hand, the expectation of rising debt servicing costs of the firm in the future diminishes the profit. Therefore, the interest rate effect deeply relies on the firm's structure and on the appraisal period, as the cash flows change their value over time. The present value inflows/outflows are lower comparing to their future value equivalent.
The expectation of interest rate and its forecasted value determine the company's estimated value. This figure is the most important for any business: the market value. The most common method of evaluation is the model of discounted cash flows. Therefore, it appears critical to the firm that the interest rate is actually not high. No matter how high profit the firm may generate in the future, high interest rate decreases this future inflow when bringing their value to the current time.
Interest Rate and the NPV Calculation
The NPV (net present value) is actually the index of company's market value, one of the four approaches of company evaluation. The method uses interest rate (cost of capital) to discount all the expected profits for particular periods to receive present value of future cash flows (Damodaran, 2006). The interest rate includes the debt and equity financing price, which correlate with the official Central Bank interest rate.
As it was already mentioned, the higher interest rates mean higher future value, but lower present value. The NPV is the present value of the company, therefore lower interest rates are more beneficial to the firm. The interrelation between market value of the firm and the monetary policy explains the activity at the stock and bond market: participants of stock trade change their behavior with the changing interest rate. For example, stock of a company with the 30%of operations financing through debt (bonds) will decrease in value when the Federal Reserve System will increase the interest rate. This happens due to the net present value decrease and its price per share, which discourages investors and current shareholders from buying/holding the stock. Such bonds of the company will also be of a lower value because the risk of default rises with the cost of capital.
The net present value is the estimation of company's ability to continue operations in the future and generate sufficient profit to lead its operations effectively. The index uses WACC (weighted average cost of capital) to determine if the future cash flow would be enough to operate and if the expected profit would be high, so that today the decision ti invest in the company is rational.
Interest Rate and the WACC
The interest rate is the outer factor in respect to the firm and it influences the part of company’s liabilities in the balance sheet. The firm has the choice to finance the operations through equity raise or debt. The WACC (weighted average cost of capital) is the index that management uses to estimate the average cost of capital, which highly depends on the firm’s capital structure (Brigham & Erhardt, 2008).
The WACC influences the company value when the method of NPV is applied for estimation. It constitutes of two main parts: cost of equity and cost of debt, which are weighted on the respectful share of equity and debt used financing. While equity cost of capital depends more on the inner company's conditions, the debt financing relies on the official interest rate. The WACC index in fact shows how much it costs to attract more money. As the interest rate increases, management will tend to restrict from additional financing or choose equity resources over debt. Though the low interest rate does not necessarily mean the low cost of capital, since the price for equity acquisition may be high (Morgan, 2014). Higher interest rates nevertheless lead to higher cost of capital.
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Interest Rate and Corporate Earnings
The investment is highly sensitive ti interest rate. The reason for such factor is that interest rates determine which type of investment can bring more profit (financial assets or physical, for example) and that influences the allocation of capital and firm's balance sheet. Rising interest rates may lead to higher business investments. First, management with free, available cash will seek for higher profits on the financial markets.
Not only current corporate earnings, and not only the cash flows from financing activities depend on the interest rate, but the structure of assets and willingness to invest (therefore generate more money on the future) may change with the interest rate increase. When the expectation oа the business future value discounted to the present is higher than the current estimation of the company (share price), the earnings of the company are to be higher than the market evaluation today and the investors would like to buy such company (Thoma, 2014).
Briefly, the rise of interest rate decreases the present value of the company, raises the cost of capital for a firm and influences the investment policy. While the Federal Reserve main incentive is to lower, restrict the rising inflation, it changes the behavior of investors and households by raising the cost of capital and as a result less gross spending.
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