During the Carter administration, long-term US Treasury yields exceeded 15%, and

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 ?

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

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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