Interest rates, and the cost of money, influence most factors related to personal and corporate capital budgeting.
You are the CFO of a company. There is new robotic equipment you want to buy. Your net present value (NPV) study shows that the new equipment will add new free cash flows to the company above the discount rate used in your NPV study. However, you have noticed that the market is indicating that the cost of capital is expected to drop in the future.
Would you, as the CFO, finance your projects as soon as possible if the cost of capital was expected to drop? Please explain.
What are the opportunity costs you must consider in this decision?
More importantly, where do you find the information to analyze expected changes in interest rates?
Solution
Week 3 Discussion
Would you, as the CFO, finance your projects as soon as possible if the cost of capital was expected to drop? Please explain.
Yes as a CFO of the company, I would invest in the project as soon as the cost of capital is expected to fall. The cost of capital is a scientific tool to measure the cost the investor must incur in order to get profits out of an investment. The idea is to minimize the cost to get the maximum profit out of the capital employed by the investor. That’s why when I would see a chance to get into a low rate of interest I would want to ensure that I take my chances as this would prevent my finances from depleting due to the higher cost of the capital. As sometimes if the costs of capital are too high it burdens the project finances and can lead.
What are the opportunity costs you must consider in this decision?
The opportunity cost is the benefit of the alternative lost in order to take up the chosen alternative. Considering this is very important in order to take up a project because that way we will know what are we sacrificing when we are talking up a project. In these decisions, we must consider the different sources of finance from where we could have got the capital to fund the project like equity and various sources of debts, that are on offer in the capital market. If we are considering borrowed finance we need to find different sources of it and its costs, its payback period is a few things to consider when we will be computing the opportunity cost.
More importantly, where do you find the information to analyze expected changes in interest rates?
The information we need to find the information to analyze expected changes in interest rates is mostly available in the public domain. The interest rate forecast is not available in the Fed although the information we need to derive such decisions does. We need to prepare a yield curve and through it, we can find out what to expect from the market. If we keep a check on the monetary policies of the government we will get an idea of how the interest rates might change and sync our policies accordingly(Jarociński, & Karadi, 2020 p.g. 39).
References
Grabowski, R. J. (2018). The size effect continues to be relevant when estimating the cost of capital. Business Valuation Review, 37(3), 93-109.
Jarociński, M., & Karadi, P. (2020). Deconstructing monetary policy surprises—the role of information shocks. American Economic Journal: Macroeconomics, 12(2), 1-43.
