Chapter 16 - impact of interest and exchange rate changes on business Flashcards
what is the relationship between present value of future cash flows and cost of capital
net present value of a project and value of a company are affected by cost of capital being used as a discount factor
higher cost of capital –> future cash flows are more heavily discounted –> lower present value
impact of interest rate change on cost of capital
if they RISE, investors expect higher return so COST of CAPITAL RISES
impact/intention of raising interest rates for businesses
- to decrease present value of cash inflows from planned investments = fall in investment
- decrease share price of a company
- companies paying higher rate of interest on debt = rise in costs, fall in profits
all have adverse business performance impact
how to calculate impact on present value of future cash flow following a rise in cost of capital
the present value of a constant cash flow in perpetuity is calculated by multiplying the cash flow by 1/r
impact on AD of an interest rate rise
- consumer spending falls
- investment spending falls
- export demand may fall
- gov spending may fall
impact of interest rate changes on exchange rates
- HIGHER ir = rise in demand from overseas investors looking to put money on deposit in local economy = DEMAND will rise
- HIGHER ir = fall in consumer demand = fall in demand for imported goods = SUPPLY will fall
impact of changes in demand and supply for currency on exchange rate
RISE in DEMAND and FALL in SUPPLY = rise in exchange rate
so:
HIGHER IR = HIGHER EXCH RATE
impact of exchange rate on export sales revenue and cost of imported goods
if EXCH RATE FALLS = export sales revenue will RISE (business receives more of its domestic currency when selling unit overseas = prices reduce and sales rise)
if EXCH RATE RISES = cost of imported goods will FALL (business will pay less in domestic currency when buying its unit from overseas supplier = lower costs and higher profits)
what is transaction risk
TRANSACTION RISK = if exchange rate moves after a transaction has been agreed = transaction risk
any losses through transaction risk are recorded in an exchange losses account and will reduce companys profit
what is translation risk
movements in exchange rate affects value of domestic currency of foreign assets/liabilities = TRANSLATION risk
impact of exchange rate on foreign asset value/liability
if EXCH RATE falls = foreign asset value will RISE (foreign assets worth more in domestic currency)
if EXCH RATE rises = foreign liability value FALLS (business will pay less in its domestic currency to repay foreign loans)
how can a company manage translation risk
to manage translation risk a company has assets in a foreign currency that they often match to foreign liabilities
what are the techniques a business can used to manage the risk of interest rate and exchange rate changes
- FORWARD CONTRACTS
- FUTURES
- OPTIONS
what are forward contracts
- signed between a business and bank that:
FIX an agreed EXCH RATE used on future transaction
FIX on agreed IR applied to future loan
drawbacks:
- bank is unlikely to offer attractive rate because they want profit
- if either rate moves in an ideal way for business, they dont benefit
- for a fixed date so company needs to be certain about timing of transactions before entering into a contract
what are futures
futures contracts are similar to forwards:
- fix both exch/ir
differences:
- futures made in large standard contractsizes so company may not be able to manage exact risk
- traded on financial exchanges that only trade in narrow range of worlds main currencies
- futures are available for period of time but not specific date
- forwards available for longer time period than futures
