The dollar has taken a beating from various new market forces. There have been all kinds of shifts that have in one way or another helped in weakening the currency. The oil prices have been consistently rising while the appetite for food, metals, oil and materials among developing countries and China have been increasing at an unprecedented rate. To make matters worse, several factors both on the domestic and foreign markets have led to an increased demand for commodities globally. All these have combined into an undesirable alliance that has led to commodity-based inflation. Consequently, consumers in the US are faced with higher costs for basic needs such as healthcare, housing, and education. Ben Bernanke, Chairman of the Federal Reserve, has the option of raising the interest rates to control this inflation. However, this may have far-reaching impacts in all sectors of the economy. This paper analyzes the effects that such an action could have on consumer financing, the value of annuities, NPV calculations, the WACC, and corporate earnings.
Impact on consumer financing
Most facets of the economy depend on consumers dipping into their pockets and purchasing products. This means that consumers are the biggest financier of businesses. For this to happen, however, the consumers should have the spending power. If the Fed raises the interest rates to rein in inflation, then the power of expenditure among people will be reduced. This is precipitated by a number of reasons . One of these is that it discourages people from taking loans they would otherwise have taken . If for instance, one was planning on taking a loan of $ 5,000 to fund their forthcoming vacation, they may decide not to. This is because it is a loan taken for luxury and they would be unwilling to repay a higher amount of money as the high-interest rates would necessitate. Such behavior would be seen across all segments of the society as the high lending rates would push away people. Consumer spending on luxury goods will therefore reduce.
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Another factor that would limit consumer spending is the fact that people will be less willing to take plans such as mortgages and car loans. This is because the high-interest rates imposed by the Fed will force lenders to also raise their mortgage and car loan rates . Even if the rate changes just slightly from say, 4% to 5%, most of the people who were planning on taking such loans will refrain. They put their plans on hold hoping that the rates would fall, and therefore they will not have to repay a huge sum of money. Likewise, those who have liquid cash would prefer saving as they would earn more interest. Therefore, consumer spending on big-ticket items would be diminished. This can be accompanied with layoffs as businesses are no longer able to support more employees. For instance, about 3.2 million people lost their jobs in the US following the less consumer spending due to the 2008 recession.
Effect on present and future value of annuities
In case the Fed does decide to raise the interest rates, then those who have invested in annuities might be the first to enjoy the benefits. This is because a rise in the interest rates from about 5% that is presently offered by most firms (Haithcock, 2015) will lead to an increase in their values. Those who have taken an immediate or present annuity plan are likely to reap more benefits as the value of their annuities will shoot up depending on the set interest rate. They will, therefore, get more money.
On the other hand, those with a deferred annuity plan cannot be sure of gaining from higher interest rates. This is because the value of future annuities will also depend on interest rate fluctuations in the future and these might not always be in their favor because once the dollar is strong enough; the Fed might decide to lower the interest rates. Consequently, the value of these annuities might shed the profits that they gained over the period during which the rates were high. Those who get to benefit the most are the ones that can be able to cash out almost immediately after the rates are raised .
Effect on the Calculation of NPVs
The calculation of the Net Present Value (NPV) is one of the most invaluable tools in business. It enables investors to determine whether putting their money into an enterprise would be, in the long-term, beneficial or not. The interest rate is one of the independent factors that are used in such calculations, and its value may shift from time to time. Whether the interest rates are raised or lowered, they would affect the NPV and hence it is one of the things that business decision makers always have their sights on. If the rates are adjusted by even one percent , it will have far-reaching consequences on the value of the business since it will affect the business throughout its lifetime.
As such, if the Federal Reserve raises the rates, the computations will also have to be changed to accommodate the variances. The high rates will invariably decrease the future cash flows of an investment. When the amount of money flowing into the business is low, it will not grow as expected and neither will the investors get as many dividends as they expect. This is because most of the money will go into operational costs and only a small amount will be left as profits. Therefore, increased interest rates raise the cost of doing business as the worth the enterprise would not be the same as if the rates were lower. With this in mind, decision makers will be able to make informed decisions on where and how to invest their money (Bank, n.d.).
Impact on the WACC
The Weighted Average Cost of Capital (WACC) reflects how much it would cost a company to raise capital and as such is an important indicator of its financial stability. If the interest rate is increased , the cost of debt for the company is also bound to increase. This means that it will be riskier for shareholders to invest their money in the business. The majority of them will, therefore, tend to withhold funds over the fear of losing it from bad business or losses. Consequently, the cost of doing business rises as the company has to seek funds elsewhere, and may end up spending more than it intended to in paying off debts (Duff, n.d.).
This may force some business owners to avoid seeking funds at all since the possibility of accessing it is low, and hence they would be operating the business below the ideal level of productivity. Many businesses will, therefore, earn fewer profits, and the future cash flows may be significantly reduced as most of the money is not reinvested into the business but used to pay off debts or dividends. The company’s long-term growth plans may, therefore, be derailed and hence their overall WACC might also reduce as investors are not confident enough to invest their money in the enterprise.
Impact on Corporate Earnings
In any business, the standard practice is to give out dividends to investors at the end of every financial year. This is often in the form of corporate earnings and is proportional to the amount of stake one owns in the business. However, there are multiple external factors that can determine how much an investor gets apart from just the stake. One of these is the interest rates under whose regime the business is operating. If the interest rates are raised , then the amount of corporate earnings for investors across different industries will be affected (Martin, 2006). This is especially true when the company primarily relies on debts to fund its operations. Given such a possibility, most businesses tend to limit the amount of money they take from debtors since repaying them could run down the business if the rates are raised for any particular reason.
The higher interest rates will raise its cost of borrowing and consequently the amount paid out to investors will reduce. No one wants to have less corporate earnings, and therefore the valuation of the company might take a hit as some investors might choose to sell their stake, sometimes at a loss. This can mean doom to business since new investors will be unwilling to put in their money if they know that they will be earning less than the amount they expect. Moreover, not many people are willing to invest their money if the bulk of it will be used in paying off loans rather than growing the business and in the process their stake in it. However, some companies might weather the storm of high-interest rates relatively unscathed. These are those who do not have any debts or the need for debt financing. That is why it is essential for a business to minimize the number of debts
References
Bank, E . (n.d). ‘Does the Net Present Value of Future Cash Flows Increase or Decrease as the
Discount Rate Increases? Retrieved from : http://yourbusiness.azcentral.com/net-present- v alue-future-cash-flows-increase-decrease-discount-rate-increases-12255.html
Duff, V . (n.d). ‘How Does the Federal Reserve Interest Rate Policy Affect You & Your
Business?’. Retrieved f rom www.smallbusiness.chron.com/federal-reserve-interest-rate- p olicy-affect-business-365.html
Haithcock, S . ( 2015). The interest-rate struggle with annuities. Retrieved from
http://www.marketwatch.com/story/the-interest-rate-struggle-with-annuities-2015-07-28
Martin, D . (2006). ‘Interest Rates and Corporate Earnings.' Retrieved from
www.safehaven.com/article/4940/interest-rates-and-corporate-earnings
