Interest Rates Federal Reserve Interest Research Paper

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NPV

This becomes more complicated when trying to determine the changes that would occur to the net present value of today's dollars, especially given the uncertainties involved with changes in the interest rate. On the one hand, the value of future dollars (i.e. today's dollars saved) is eroded by inflation, so a lower interest rate is detrimental to NPV; on the other hand, higher interest rates mean more lucrative lending and higher returns on many investment, which would mean a dollar invested today would be worth more in the future (Investopedia 2011). At the same time, higher interest rates could slow the pace of business and damage gains in the stock market, leading to diminished returns (Magnuson 2008). The effect of interest rates on the NPV, then, depends on other macroeconomic and financial effects.

WACC

The Weighted Average Cost of Capital would basically increase due to a change in interest rates, but more important are the effects that a change in interest rates would have on the various components of the weighted average cost of capital. As borrowing becomes more expensive, a lower debt to equity ratio would become more beneficial to many companies, and less borrowing (or slower growth) would be the necessary result (Investopedia 2011). This could boost investment opportunities for many individuals, but that would mean less money would be available for purchasing goods, which has a depressive effect on the economy…. Again, it is difficult to predict what will happen in such unstable times.

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Corporate Earnings

The effect of a higher interest rate on corporate earnings is something that is simpler to determine and easier to predict. As was stated above, a higher cost of borrowing is likely to lead to a lower debt to equity ratio, meaning that corporations will finance their operations more with equity -- selling shares of the corporation -- than with debt -- borrowing from banks (Investopedia 2011). This has two effects on corporate earnings. First, it means that the company has lower liabilities and that less of its earnings have to go to interest payments, meaning that the overall earnings of the corporation are going to increase, all else being equal. Increased equity financing, however, means that there are more owners of the corporation that are entitled to a share of the profits, so the corporate earnings become more diluted and, from an individual owner or potential investor's perspective, become less valuable. This could have a negative effect on business as a whole, as corporation might decide simply to forgo growth given the options of more expensive operating through debt financing or diluted earnings through equity financing.

Conclusion

At some point, interest rates will have to increase to stave off rampant inflation. It might be wise to wait until the economy is stronger, however, so that companies and individuals feel safer with more expensive debt loads. Only time will tell which action is implemented -- and which should have been......

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