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

Interest rate refers to the rate which is earned by an investor on his/her investment from a particular financial product. Also such interest rate is also used by the investor to compare the alternative investment products with different rate of interest. It is also known as market rate of interest.

For the given case, it has been mentioned that Federal Reserve lowers interest rate in the economy to increase the economic activity. It means that the authority by lowering the interest rates allow the consumers as well as companies to lend or borrow at such rate within the economy. Also then, the investor's expectation of interest rates will be lower, that is, now an investor will be expecting lower rate of interest on his/her investment as the market rate of interest has been decreased.

Under the capital budgeting decision making tools, NPV is mostly used with discounting the cash flows with the interest rate and deducting it from the cost of project. As per the concept of time value of money, as the interest rate rises in the economy, the present value of cash flows from project will be less and as the interest rate decreases, present value of cash flows will increase.

Using such relation between interest rates and NPV technique, as the interest rate gets decreased as a result of Federal Reserve decision, NPV in case of every project will be improved as a function of interest rate in the economy.

Hence, decreasing interest rates will cause firms to make more investments.