Raising the Interest Rate
Raising the Interest Rate
Principles of Finance
Introduction
After years of declining interest rates, we are facing a dilemma; should the Federal government increase rates to contain inflation, or keep rates low to boost the US economy? Increases in consumption of oil, metals, materials, and food, both foreign and domestic, are increasing demand. Prices are rising on a global scale as demand increases. Additionally, the US is experiencing rising costs for healthcare and education. Yet, the US economy is suffering through declining home values, a banking crisis, and an uncertain stock 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 may 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 (WACC)
WACC 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 WACC calculation (Investopedia.com). As the cost of capital is measured by looking at what amount is tied up in debt, equipment, and lost opportunity costs, the WACC 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 WACC. If the cost of debt rises to 15 percent and
Principles of Finance
Introduction
After years of declining interest rates, we are facing a dilemma; should the Federal government increase rates to contain inflation, or keep rates low to boost the US economy? Increases in consumption of oil, metals, materials, and food, both foreign and domestic, are increasing demand. Prices are rising on a global scale as demand increases. Additionally, the US is experiencing rising costs for healthcare and education. Yet, the US economy is suffering through declining home values, a banking crisis, and an uncertain stock 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 may 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 (WACC)
WACC 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 WACC calculation (Investopedia.com). As the cost of capital is measured by looking at what amount is tied up in debt, equipment, and lost opportunity costs, the WACC 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 WACC. If the cost of debt rises to 15 percent and
References: Robaton, A. (2014, April 16). CNBC.com. Retrieved October 13, 2014, from http://www.cnbc.com/id/101575989#. Investopedia.com. (n.d). Retrieved October 13, 2014, from http://www.investopedia.com/terms/f/future-value-annuity.asp Networkplaces.com. (n.d). Retrieved October 16, 2014, from http://www.netplaces.com/investing/a-look-at-the-big-picture/how-interest-rates-affect-everything.htm Clements, J. (2014, September 3). ehow.com. Retrieved October 16, 2014, from http://www.ehow.com/info_12036641_relationship-between-interest-rates-npv-irr.html Investopedia.com. (n.d). Retrieved October 17, 2014, from http://www.investopedia.com/terms/w/wacc.asp