Interest rates exert the following economic influences.
- Interest rates in a country influence the foreign exchange value of the country’s currency.
- Interest rates act as a guide to the return that a company’s shareholders might want, and changes in market interest rates will affect share prices.
A positive real rate of interest enhances an investor’s real wealth to the income he earns from his investments. However, when interest rates go up or down, perhaps due to a rise or fall in the rate of inflation, there will also be a potential capital loss or gain for the investor. In other words, the market value of interest-bearing securities will alter. Market values will fall when interest rates go up and vice versa.
Interest Rates are Important for Financial Decisions by Companies
Interest rate is important for financial decisions by companies. The incidence of the interest rates can have the following effects.
1. When interest rates are low, it might be beneficial:
- To borrow more, preferably at a fixed rate of interest, and so increase the company’s gearing,
- To borrow for long periods rather than for short periods,
- To pay back loans which incur a high interest rate, if it is within the company’s power to do so, and take out new loans at a lower interest rate.
2. When interest rates are higher:
- A company might decide to reduce the amount of its debt finance, and to substitute equity finance, such as retained earnings,
- A company which has a large surplus of cash and liquid funds to invest might switch some of its short-term investments out of equities and into interest bearing securities,
- A company might opt to raise new finance by borrowing short-term funds and debt at a variable interest rate (for example on overdraft) rather than long-term funds at fixed rates of interest, in the hope that interest rates will soon come down again.
Interest Rates and New Capital Investments
When interest rates go up, consequently the cost of finance to a company also goes up; the minimum return that a company will require on its own new capital investments also goes up. A company’s management is supposed to give close consideration, when interest rates are high, keeping investments in assets, particularly unwanted or inefficient fixed assets, stocks and debtors, down to a minimum. This activity of the company is done in order to reduce the company’s need to borrow. At the same time, the management also needs to bear in mind the deflationary effect of high interest rates that deters spending by raising the cost of borrowing.
Interest Rates and Share Prices
When interest rates change, the return expected by investors from shares also tends to change. For example, if interest rates fall from 14 percent to 12 percent on government securities, and from 15 percent to 13 percent on company debentures, the return expected from shares (dividends and capital growth) would also fall. This is because shares and debt are alternative ways of investing money. If interest rates fall, shares become more attractive to buy. As demand for shares increases, their prices too rise, and so the dividend return gained from them falls in percentage terms.
Credit: Strategic Financial Management-MGU