Implications of interest rate changes on the computed net present value

Implications of interest rate changes on the computed net present value

Any change in the interest rate will not only impact the attractiveness of the investment on stocks but also the net present value of the company, as it will directly affect the future value of money (Gitman et al., 2015). The current analysis focuses on the impact that the interest rate changes have on the net present value of the company and its future value, while the effect that the interest rate changes have on the stock’s appeal will be analyzed as part of the evaluation of the stock market in the next section.

As stated previously, any change in the interest rate will have a direct impact on the future value of the company and hence its current or net present value. Such relationship results from the concept of the time value of money, and can be described as indicated by the formula below:

Where CF accounts for the cash flow in the corresponding year and i is the interest rate considered in the calculation of the present value of the company. As per this formula, an increase in the interest rate will result in a lower PV, while a decrease in the interest rate will result in a higher present value, since the interest rate (i) is in the denominator of the equation, hence being inversely proportional to the present value.

Table A1 illustrates this effect by comparing the present value of the company assuming three different scenarios. The first scenario shown in the table is the current situation, in which the company considers an interest rate of 8%. The present value of the company in this scenario is of $13.6 billion. When the interest rate decreases to a value of, e.g., 5% as shown in the second scenario, the present value of the company increases to $14.3 billion hence representing an increase of $700 million or 5%. In contrast, if the interest rate increases to, e.g., a 15% as shown in the third scenario, the present value of the company decreases to $12.2 billion dollars, representing a decrease of $1.4 billion or 11%.

Possible impact of an event in the stock market on the company’s stock valuation numbers

The second impact of a change in the interest rate, as outlined in the previous section, is that it will affect the appeal of stock investment. In this regard, an increase of the interest rate is an adverse event for the stock market, as investors will perceive that they can earn a higher return on alternative investments. In contrast, a decrease of the interest rate often promotes the investment on stocks as investors try to search for higher yields. Consequently, a reduction in the interest rate will increase the appeal of stock investments, and increase the demand for the company’s stocks hence increasing their price. On the other hand, as investors sell their stocks looking for the high returns achievable in safer investment options when the interest rates rise, the demand of the company’s shares will decrease, which will most likely decrease their price unless the company presents outstanding financial results keeping a good image for the investors.

External factors that may affect the company’s financial performance

Several external factors may affect the financial performance of the company. Some examples of those that we treated in the course include the fiscal and monetary policies implemented by the government. For example, a modification of the tax rate will determine how much money the company gets to keep as net income and how much it will have to pay in the form of taxes (Gitman et al., 2015). Similarly, a modification of the interest rate results in an increase or decrease of the company’s value (Gitman et al., 2015).

References

Gitman, L. J., Juchau, R., & Flanagan, J. (2015). Principles of managerial finance. Pearson Higher Education AU.