If the Fed decides to raise interest rates next year, what effect would rising r
ID: 2670894 • Letter: I
Question
If the Fed decides to raise interest rates next year, what effect would rising rates have upon the following: (1) Consumer financing for big-ticket items such as autos and homes; (2) the present and future values of annuities; (3) the NPV calculation (4) the WACC (5) corporate earnings ?Please illustrate with relevant financial numbers. For example,one approach you might adopt is to contrast NPV calculation against a new calculation performed with a higher interest rate. Cite the numeric effect upon the NPV, and then explain its rationale and its significance.Provide numeric illustration for each of the five topic sections.
Explanation / Answer
Raising interest rates next year would have the following effects on each of these listed items: (1) Consumer financing for big-ticket items such as autos and homes would be more difficult to obtain, since the higher interest rates would make monthly payments higher over the extended period of long-term home mortgages or auto loans. (2) the present and future values of annuities would have increases because interest rates, when raised, would allow the investors who work for the annuity companies to make greater dividends and gains on the principal invested on behalf of the annuitant and beneficiaries. Then, when the annuity was paid out, the payments would be greater than if interest rates were not raised. (3) the NPV calculation would result in a lower net present value, because the result of the NPV formula would decrease as the interest rate (r) increased. Also, since an increase in the interest rate would result naturally in inflation, the present value would decrease. (4) the WACC (weighted average cost of capital) would increase because higher interest rates would increase the expectations of investors who would demand greater returns on their investments in a company. Also, this increase would result from the WACC formula in which higher required rate of return (r) causes a higher WACC. (5) corporate earnings would have to increase for reasons similar to the WACC because investors would expect higher rates of return on investments (ROI). Corporations would have to increase their earnings to pay higher dividends.
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