This paper examines the potential economic and financial impacts of rising interest rates from a corporate finance perspective. Drawing on supply-and-demand theory, annuity valuation, net present value (NPV) analysis, and cost of capital concepts, the paper illustrates how even modest interest rate increases ripple through consumer financing, investment appraisal, and firm funding decisions. Concrete numerical examples — including loan repayment comparisons and discounted cash flow tables — demonstrate the mechanics behind each impact. The paper was written in the context of historically low U.S. Federal Reserve rates following the 2008 financial crisis, anticipating the eventual return to higher rate environments.
Interest rates exert a strong influence on the economy. This influence is one reason many central banks utilize interest rates as a monetary tool in an effort to control the supply of money. Since December 2008, the U.S. has seen some of the lowest central bank interest rates on record, with the Federal Reserve holding rates down in order to help stimulate economic growth. The Federal Reserve had forecast interest rates remaining close to zero until some point in 2013, but at some point they would have to increase (Anonymous, 2011). When interest rates do rise, the increase impacts a number of areas of the economy; this paper considers some of those impacts.
Big-ticket items are expensive goods that will often require the purchaser to obtain some form of credit. If interest rates increase, this is likely to have a negative impact on demand for those goods, as they become more expensive to purchase. This can be illustrated with a simple example: a consumer is considering buying a car for $10,000, which they will finance with a five-year loan. The impact of increasing interest rates is shown in the table below.
Table 1: $10,000 loan over 5 years at differing interest rates
Loan at 5% / Loan at 7% / Loan at 9%
Monthly repayment: $188.61 / $198.01 / $207.58
Total interest: $1,322.60 / $1,880.60 / $2,454.80
Total repaid over term of loan: $11,322.60 / $11,880.60 / $12,454.80
As repayments increase, demand is likely to change. There is a general relationship between supply and demand: as prices for goods decrease, demand usually increases (Nellis and Parker, 2006). The converse is also true — when prices increase, demand will usually decrease (Nellis and Parker, 2006). When a purchaser uses financing, the monthly loan repayment is effectively part of the price of the good. As shown above, if the car loan repayment increases from $188.61 to $207.58 per month, this represents an effective increase of $18.97 in the monthly cost of the purchase. Where buying becomes more expensive, demand for big-ticket items from buyers using loans is likely to fall. Consumers may choose alternatives such as prolonging the life of existing big-ticket items, repairing rather than replacing mechanical goods, or extending or improving a home rather than moving (Nellis and Parker, 2006). If purchases are still made, demand may shift toward the lower-priced end of the market. Therefore, the total value of the market for big-ticket items is likely to decrease.
An annuity is the purchase of a regular income with a capital lump sum. The rates offered for annuities reflect prevailing market conditions. The firm selling the annuity invests the lump sum with the aim of making a return greater than the regular payments it makes to the annuity holder. If interest rates are low, the returns the firm can gain are low; when interest rates increase, annuity rates will eventually increase as well, although there is likely to be a lag.
This relationship — whereby annuity rates change when interest rates change — can be observed in historical performance data. Using figures from the UK pension annuity market, the respected firm William Burrows Annuities compared annuity rates in April 2008, when the Bank of England base rate was 5%, to April 2011, when rates had fallen to 0.5% (Currie, 2011). Using a benchmark of a £100,000 capital lump sum, the annuity income in 2008 would have been £6,547 per annum; by 2011 this figure had decreased to £5,943 per annum (Currie, 2011).
The calculation of the present value of an annuity is complex, as it involves discounting future cash flows into today's value. If interest rates increase, the cash flow from the annuity increases, raising the future value. The present value will depend on inflation: inflation may increase, but if the economy is managed correctly, inflation should be held at a rate lower than the proportional increase in interest rates. Theoretically, the present value may also increase, but this effect will be less pronounced compared to the future value and depends on many divergent factors. These include not only inflation but also issues not directly related to interest rates, such as the cost of labor and the price of oil.
Net present value (NPV) calculations look at the value of an investment in the future by taking its future cash flows and discounting them into today's value, thereby accounting for the time value of money. The discount rate may be based on the expected rate of inflation; however, firms will often base the discount rate on their actual cost of capital (Drake and Fabozzi, 2009). As interest rates increase, the cost of capital — which is discussed in the next section — will also increase. Assuming the same cash flows, the following tables demonstrate the difference that an increase in interest rates will have on NPV. The example used is a five-year investment of $10,000 generating an annual return of $3,500. In Table 2, the discount rate applied varies to illustrate this effect.
"Rising discount rates reduce net present value"
You’re 84% through this paper. Sign up to read the remaining 1 section.
Sign Up Now — Instant Access Already a member? Log inAlways verify citation format against your institution’s current style guide requirements.