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

Lower rates will decrease the cost of capital or thus the opportunity cost/discount rate for a project.

We know that NPV is inversely proportional to discount rate hence when discount rate decreases NPV increases. Higher NPV means better project. It may so happen that before rates decrease, NPV was negative and hence the firm would not want to make the investment. But after rates decrease the firm will make the investment.

Similarly, according to IRR a project should be accepted when IRR is more than discount rate. It may so happen that before rates decrease, IRR was less than discount rate and hence the firm would not want to make the investment. But after rates decrease the firm will make the investment.

Thus we see lower rates lead to higher investments.