Question

The Federal Reserve lowers interest rates in the economy to increase economic activity. Using the capital budget decision tools, discuss how decreasing interest rates can cause firms to make more investments

Answer 1

When the federal reserve lowers interest rates in the economy, due to transmission effect, the risk free rates and corresponding lending rates linked to the risk free rates will reduce. This effective reduction will reduce the cost of capital for a firm. The cost of capital is the weighted average cost of debt and equity. Cost of debt is linked to the treasury rates and as treasury rates gets lower the cost of debt also reduces. The cost of equity is linked to the risk free rate which also reduces as a result of lowering of interest rates in the economy.

The overall cost of capital is now considered for decision making using capital budgeting tools like NPV, IRR, Discounted cash flows.

NPV - Using NPV decision making rule, as the cost of capital is reduced, the NPV becomes higher thus providing a higher valuation for the investment and more returns.

IRR - Using IRR decision making rule, as the cost of capital is reduced, the IRR decision making rule would become much easier as IRR has to be greater than cost of capital.