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

Tools of capital budgeting: 1. Payback 2.Discounted Payback 3.IRR 4.Profitability Index 5 . NPV

In above tools, the important thing to consider is discount rate.

Discount rate is the function of Cost of Capital. With lowering in interest rates, loans become cheaper and with that cost of capital goes down and so does discount rate.

With cheaper funds in hand, it becomes easier for the firms to invest in profitable projects.

As the discount rate goes down,

1. discounted payback period goes down.

2. IRR improves

3. Projects become more profitable

4. NPV goes up

Thus lowering interest rate can cause firms make more investments