CIMA BA1 Syllabus D. The Financial Context Of Business - Impact of interest rates changes - Notes ^{2 / 8}

Direct impact on business performance

The net present value of a project and the value of a company are affected by the cost of capital being used as a discount factor

The relationship between the present value of future cash flows and the cost of capital is shown below.

If interest rates rise (for example due to government policy)

then investors will expect a higher return and the cost of capital will rise. 

So the impact of higher interest rates will often be to:

• Decrease the present value of cash inflows from planned investments (investment means spending on new asset creation, eg new factories), leading to a fall in investment.

• Decrease the share price of a company

  Share price is influenced by the present value of a company's forecast cash inflows.

• A company will have to pay a higher rate of interest on its debt if interest rates rise

  Therefore, will see a rise in costs and a fall in profits.

These effects will have an adverse impact on business performance and they are likely to lead to significant falls in a company's share price.

Example

Calculate the impact on the present value of a future cash flow of $10,000 per year receivable into perpetuity, if the cost of capital rises from 2% to 4%.

Solution

The present value of a constant cash flow in perpetuity is calculated by multiplying the cash flow by 1 / r.

If r = 2% the present value is $10,000 x 1 / 0.02 = $500,000
If r = 4% the present value is $10,000 x 1 / 0.04 = $250,000

This is a decline of $250,000 (ie 50% fall from the original value of $500,000)

Indirect impact on business performance

Where the trade cycle is at its boom phase, and resources are already fully employed there may be an inflationary gap.

If demand is too high the central bank may increase interest rates to shift the aggregate demand (AD) curve to the left, from AD1 to AD2.

As we know, AD consists of:

• Consumer spending on domestically produced goods (C)

• Investment spending (l)

• Government spending (G)

• Exports (X)

This is sometimes expressed as AD = C + I + G + X

This fall in demand will indirectly impact on business performance because the general level of demand in the economy will fall.

Impact of interest rate changes on exchange rates

The exchange rate is determined by the forces of demand and supply (ie demand for a currency in relation to supply of that currency).

• Interest rates will affect the demand for a currency

  eg higher interest rates will cause a rise in demand from overseas investors looking to put money on deposit in the local economy

  ie demand will rise.

• Interest rates will also affect the supply of a currency

  eg higher interest rates cause a fall in consumer demand and therefore a fall in demand for imported goods (as well as locally produced goods)

  ie supply will fall.

• A rise in demand for a currency and a fall in the supply of currency will both lead to a rise in the exchange rate. 

  Therefore, an increase in interest rates in a country would be expected to lead to an increase in the exchange rate for its currency.

A change in the exchange rate will have an impact on business performance.

This impact is summarised below and is developed in the next section.