Yet, the US economy is suffering through declining home values, a banking crisis, and an uncertain tock market. So, what would an increase in the interest rate mean for consumer financing for big-ticket items, the present and future values of annuities; net present values, weighted average costs of capital, and corporate earnings? Cost of Capital The cost of capital can be measured in a variety of ways. One may look at short, and long-term debt where payments will rise as interest rates rise, increasing capital costs.
Or, one might consider that shifting interest rates create difficulties in predicting future capital costs, so some organizations ay find themselves incurring greater costs than expected. Also, with increased interest rates, money becomes more valuable invested in interest- bearing bonds, or saved, versus spent. Weighted Average Cost of Capital (WAC) WAC is the calculation of a firm’s cost of capital. All capital sources common stock, preferred stock, bonds and any other long-term debt – are included in a WAC calculation (Investigated. Mom). As the cost of capital is measured by looking at what amount is tied up in debt, equipment, and lost opportunity costs, the WAC percentage tells an important story. For example, if an organization has a capital structure of 78 percent equity, 22 percent debt, 11 percent tax cost of debt, and a cost of equity at 15 percent; they would have a 13. 52 percent WAC. If the cost of debt rises to 15 percent and equity to 19 percent (each up 4 points) due to interest rate increases, the WAC becomes 17. 3 percent.
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Such increases show a decrease in value, a higher risk for investment returns, impact Net Present Value as organizations often use the WAC to discount cash flows. As WAC percentages rise, firms will invest less. Net Present Value (NAP) Net Present Value (NAP) is crucial in determining if an investment is worth making. Organizations look at the NAP to ensure that their investment will be profitable for the organization, and that they will experience positive returns. As interest rates rise, NAP drops. As NAP drops, companies tend to save versus invest.
Evaluating a Project When evaluating a project using the Whack’s of 13. 52 percent and 17. 3 percent one sees the following impact of rising interest rates: Suppose the organization has cash flows of -$1 ,OHO, $350, $480, $520, $600, and $100 over five years. With a discount rate of 13. 2 percent NAP becomes $450. 59 while with 17. 3 percent NAP is $331. 38. As the discount rate, or interest rate, continues to rise the NAP drops. Fifth NAP drops below zero, due to high interest rates, the project would not be viable. What is the Impact on the Economy?
Consumer Financing Increasing interest rates equal variable debt increases. Such increases create higher monthly payments for credit cards, home-equity lines, and for any accounts with floating rates. Big ticket items, such as cars, homes, and boats, will cost more to finance. With costs increasing, many companies will raise heir prices to offset their higher capital costs causing households to reevaluate their existing spending levels. Higher interest rates will help control inflation costs, but will exacerbate the already struggling housing market. Corporate Earnings drop when interest rates increase.
The more subtle impact of increasing interest rates is the overall increase in virtually the cost of everything. Corporations will begin to experience increasing costs of capital and will therefore pass along these costs to the public through higher prices. Additionally, as corporations most pay more to borrow money, they eave less money available to pay dividends, and less to invest in future growth. Diminishing profits may cause share prices to drop pushing down stock prices. Future Value of Annuities Not all outcomes of rising interest rates are negative.
Annuities are investments which pay out annually and can be fixed or variable. Variable annuities benefit from increasing interest rates because as interest rates rise so does the future value of the annuity. Promising Returns If we look at an annuity starting with a $700 annuity payment over the next six years at 10 percent interest, the future value is $5,400. 93. With an increase in rate to 15 percent this same annuity increases value to $9,1 91. 43. A five point jump in the interest rates almost doubles the future value of the annuity.
Show growth in returns promote investment in annuities boosting the future Of the economy as more individuals save for the future. Conclusion So, in looking at what an increase in the interest rate would mean for annuities, net present values, weighted average costs of capital, and corporate earnings, it shows the overall impact as unfavorable. Raising the interest rate creates diminished earnings and lower stock values, makes rowing money more expensive, and raises the cost of capital thereby increasing the WAC and decreasing the NAP.