# Application report 2

Application Report 2 The Impact of Consumer Financing On Big-Ticket Items Such As Autos and Homes If the Fed decides to raise interest rate next year there will be impact on everything including big ticket home loans, vehicle loans. The rise in interest rate will increase the cost of capital and it will have the impact on consumer financing.
We can calculate the impact by the illustration on financing for autos.
Assuming currently a vehicle loan is available at 6 percent per year of interest rate and the cost of vehicle is \$12, 000. One needs to make down payment of \$2000. The loan finance for \$10, 000 is available for the duration of 60 months. The monthly payment will cover principal and interest there on. The working is on reducing balance basis.
The auto calculator indicates a monthly auto loan payment installment as \$193.
Fed has increased the interest rates and now vehicle loan is disbursed at 8 percent instead of 6 percent. Obviously, the monthly loan installment payment will go up.
The auto calculator indicates a monthly auto loan payment installment as \$203.
Similarly the impact on home loans can also be calculated with the rising rates.
The Present and Future Values of Annuities
The rise in federal interest rate causes general increase in the cost of capital. This leads to the increase in the cost of manufacturing and services. The present value of annuity such as pension will decrease because the value of dollar or purchasing power of dollar will fall.
Taking the case of retirees who receive an annuity of \$40, 000 every year, the present value for them at the interest rate of 5 % will be 40, 000/1. 05= \$38, 095
However, with the rise in interest cost the higher interest rate of 6% will reduce the present value of annuity to 40, 000/1. 06= \$37, 735. The person has lost \$360 due to rise in the cost of living. Vice versa is also true. Further, the future value of the money invested will rise along with the rise in interest cost.
NPV Calculation
The NPV for the stream of annuities received can also be calculated in the same way,
NPV = A1/(1+r) + A2/(1+r)2 + A3/(1+r)3 …
A1, A2, A3 are the annuities received at the end of first, second, third year and onwards. The ‘ r’ is the interest rate applied.
Assuming annuity received every year is \$1, 000 for the period of 5 years at the interest rate of 5% per year, the net present value
= 1000/1. 05+1000/1. 052+1000/1. 053+1000/1. 054+1000/1. 055
= 952. 38+907. 03+863. 38+822. 7+783. 53
= \$4329
The significance of above calculation is that total annuity though received is \$5000 yet actual worth is \$4329 only. The worth will further be reduced if interest rate is still high, say, 7 %. The quick calculation can be done with the same equation.
= 1000/1. 07+1000/1. 072+1000/1. 073+1000/1. 074+1000/1. 075
= 934. 58+873. 44+816. 3+762. 9+713
=\$4100
The worth of \$5000 has further reduced to \$4100 from the earlier \$4329
The WACC
Firms calculate weighted average cost of capital that depends upon the cost of equity and the cost of debt. The cost of debt will rise with the rise in interest cost as company will need to give higher interest on its borrowings. The increase in the cost of debt will also increase the cost of equity because the cost of equity rules a few percentage points higher (usually 5 to 10% depending upon the risk profile of the company) than the debt cost.
Hence, the WACC of the company will increase with increase in the interest rate.
The Corporate Earnings
The higher interest cost will result into higher production cost of the product or services. If the company is unable to pass the increased cost to the consumers then it will reflect into the reduced earnings of the company for a given year. The net profit of the company is calculated by deducting the interest paid on the debt in a given year; however lesser earnings in a given year may also result into lesser dividend for shareholders.
The corporate earnings will be impacted negatively with the increase in interest charges.
References
1. United States Interest Rate Online from 6 August 2011, http://www. tradingeconomics. com/united-states/interest-rate
2. Auto calculator, online from 6 August 2011, http://www. bankrate. com/calculators/auto/auto-loan-calculator. aspx
3. Darwin’s Money, online from 6 August 2011, http://www. darwinsmoney. com/present-value-of-money-explained/
4. Weighted Average Cost Of Capital – WACC, online from 6 August, 2011 http://www. investopedia. com/terms/w/wacc. asp