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Business and Interest Rates


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This revision presentation explains the role of interest rates and how they affect both the cost of business finance and the wider impact on business demand.

Published in: Business, Economy & Finance

Business and Interest Rates

  1. 1. Business & Interest Rates
  2. 2. Key topics to consider• Credit – why businesses need it• What is an interest rate?• Who sets interest rates?• How businesses are affected by changes in interest rates
  3. 3. What is credit? Credit is about borrowing – owingmoney to others for a period of time
  4. 4. Why do businesses need credit?• To finance purchase of assets (e.g. stocks, machinery, computers)• To allow customers to take time to pay their bills• To support the growth of the business (e.g. new locations, extra staff)
  5. 5. Examples of business credit• A business uses its bank overdraft facility – e.g. the bank account goes £50,000 “into the red” or overdrawn• A business takes out a bank loan – e.g. £100,000 loaned over five years• A business buys goods or services from a supplier and agrees to pay for them in 30 days – this is known as trade credit
  6. 6. How much credit can a business obtain? It depends on…• Whether the business is profitable and is likely to remain so in the future• The ability of the business to generate a positive cash flow to allow it to repay credit• The strength of the relationship between the business and its creditors• The industry or market in which the business operates
  7. 7. What happened in the “credit crunch”?• Banks withdrew or lowered overdraft facilities• Banks refused to provide bank loans, or made the repayments and interest charges worse• Suppliers insisted on earlier payment of invoices• Customers took longer to pay their bills
  8. 8. What is an interest rate?An interest rate is the cost of borrowingmoney or the return for investing money
  9. 9. Interest payments & receipts Interest Paid Interest Received Paid to bank when overdrawnPaid to bank on a bank Paid by bank on cash loan balances held Paid to credit card Paid by customers if they companies are late settling invoices Paid to leasing companies
  10. 10. The base rate
  11. 11. Who sets the interest rate? The base interest rate inthe UK economy is set by the Bank of England. Each month, the Monetary PolicyCommittee of the Bank of England to decide what the base rate should be
  12. 12. Interest rates & monetary policy• Monetary policy involves the use of interest rates and other monetary measures to : – Influence bank lending – Control the growth of aggregate demand – Control the demand for and supply of money – Influence the external value of the currency• The Bank of England operates UK monetary policy on behalf of the government• The main objective of monetary policy is price stability and the main policy weapon is interest rates
  13. 13. What has happened to interest rates in the UK? During the credit crunch, the base interest rate has fallen sharply to as low as 0.5%
  14. 14. Interest rate changes affect the whole economy• Exports and imports • Demand for loans• Balance of payments • Consumer confidence• Exchange rate • Demand for goods• Housing market • Consumer demand• Unemployment • Investment - demand• Economic growth for capital goods • Inflation
  15. 15. Business and interest rates• Effect of a change in interest rates on business depends on:• The amount that a business has borrowed and on what terms• The cash balances that a business holds• Whether the business operates in markets that depend on consumer spending
  16. 16. The effect on consumer demand• The demand for goods and services is likely to fall as a result of a rise in interest rates : – Consumers might choose to save rather than spend – They will be less willing to make credit purchases – Mortgage holders suffer a fall in discretionary income following the rise in monthly mortgage payments• But a rise in interest rates will not impact equally on all parts of the economy• It will impact disproportionately on demand for luxury goods and on demand for goods purchased on credit
  17. 17. The effect on business investment• Rise in the cost of borrowing will reduce the profitability of a proposed investment• Investment will be less attractive because: – It will cost more to borrow money – Customer demand will be lower – The expected return on investment will be lower – The payback period will be longer
  18. 18. Examples of markets which suffer from an increase in interest rates• Housing (mortgages)• Motor vehicles• Holidays• “Big ticket” consumer goods – e.g. new kitchens, audio-visual systems
  19. 19. How should a business respond?• Will the rise in interest rates be temporary or long term?• Will the rate rise be followed by further rate rises?• To what extent is the business in question affected?
  20. 20. If an interest rate rise is a problem• Price discounts to stimulate demand• Cost cutting to maintain margins and conserve cash• Reduce capacity – e.g. short time work, redundancies• Improve management of working capital (e.g. destocking)• Reduce the debt burden• Cut back on investment plans
  21. 21. Banks and interest rates• Banks pay interest on customer deposits and they charge interest on money borrowed• Banks set their own interest rates but the minimum they charge is set by the monetary authorities – i.e. the Bank of England
  22. 22. Interest rates & exchange rates• High interest rates in the UK (compared with other countries) will cause an inflow of capital into the UK• This increases the demand for sterling and reduces the supply• As a result the exchange rate goes up• A stronger currency will make exports more expensive (thus reducing volume) and imports cheaper (thus increasing volume)
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