During the Carter administration, long-term US Treasury yields exceeded 15%, and
ID: 2635094 • Letter: D
Question
During the Carter administration, long-term US Treasury yields exceeded 15%, and short-term T-Bills yielded near 20%. After Reagan's inauguration, interest rates began to fall as Fed Chairman Volcker's restrictive monetary policy succeeded in containing inflation. Over the past 25 years, US rates have steadily declined: T-Bills are hovering under 1% and the long bond is yielding about 4%. Lately, though, rising oil prices have incited inflationary forces. China and other developing nations have increased their consumption for oil, metals, materials, and food. Thus, both foreign and domestic factors have spurred demand and are contributing to rising prices on a global scale. In addition to this commodity-induced inflation, US consumers are faced with rising costs for essential services such as healthcare and education. The Chairman of the Federal Reserve, Ben Bernanke, is faced with a dilemma. Should the Fed increase rates to contain inflation; or, should the Fed keep rates very low to spur the US economy which is beset by a collapse in home values, an extensive banking crisis, and a faltering stock market ? YOUR ASSIGNMENT: Given this economic background...Compose a 2-4 page report, single-spaced, on the following topic: 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 ?
Explanation / Answer
The interest rates in the USA economy started declining from time to time because of the better monetary policies by Federal Reserve from time to time. This was possible because of the opening of economies and permission for FDI in the country. However Federal Reserve has played a crucial role in this context with the help of government in many situations like the corporate failures, sub-prime crisis or the high per inflation. The money policy by Ben Bernanke could control the interest in the market. Now let us discuss how the interest rise in the interest would be impacting the following items:
1.)))
Consumer financing for big-ticket items such as autos and homes
Let us assume that Mr. Clinton has availed a home loan from Bank of America for a loan amount of $1,000,000 under his individual capacity. When Mr.Clinton availed the loan, it was below:
Before Interest Change
Loan Amount
=
1000000
Tenor
=
240
Months
Rate Of Interest
=
4%
P.A.
Instalment
=
$ 6,060
(Excel "PMT" Function Is Used)
Suppose Mr. Clinton is continuing the repayment of the loan with rate interest @4% p.a. and let us assumes that, he has paid $20,000 of principal for the loan availed. Now after the interest rate change to 5%, following is the instalment calculation:
After Interest Change
Loan Amount
=
$ 9,80,000
Tenor
=
228
Months
Rate Of Interest
=
5%
P.A.
Instalment
=
$ 6,667
(Excel "PMT" Function Is Used)
Increase In Instalment due to increase in interest rate
=
$ 607
2.)))
The present value of annuity
Let us assume that the present instalment amount is $6,060 with a tenor of 240 months. This install amount has been arrived at, with considerations of interest rate of 4%. Present value of the annuities indicates that, the present value of cash flows with a particular rate of interest. As per this the present value of the instalments are as below:
Before Interest Change
Let us assume, the Instalment
=
$ 6,060
Tenor
=
240
Rate of Interest
=
4%
P.A.
Present Value of Annuity
=
$ 10,00,000
(Excel "PV" Function Is Used)
After Interest Change
Let us assume, the instalment
=
$ 6,060
Tenor
=
240
Rate of Interest
=
5%
P.A.
Present Value of Annuity
=
$ 9,18,214
(Excel "PV" Function Is Used)
Difference In Present Value due interest change
=
$ - 81,786
The negative sign indicates that, because of increase in the interest rates, the value of the present value has come down so drastically.
The future value of annuity
Future Value is an amount, which is the compounded amount for a particular amount with a particular rate of interest and for a specific tenor. Now we may observe that, because of change in interest rates, there is a change in the future value of the amount.
Before Interest Change
Let us assume, the Instalment
=
$ 6,060
Tenor
=
240
Rate of Interest
=
4%
P.A.
Future Value of Annuity
=
$ 22,22,582
(Excel "FV" Function Is Used)
After Interest Change
Let us assume, the Instalment
=
$ 6,060
Tenor
=
240
Rate of Interest
=
5%
P.A.
Future Value of Annuity
=
$ 24,90,783
(Excel "FV" Function Is Used)
Difference In Future Value due interest change
=
$ 2,68,201
Before Interest Change
Loan Amount
=
1000000
Tenor
=
240
Months
Rate Of Interest
=
4%
P.A.
Instalment
=
$ 6,060
(Excel "PMT" Function Is Used)
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