Interest Rates and Their Effect on Business Investment

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Interest Rates and Their Effect on Business Investment

Business Essentials · Chapter 23: Money and the Federal ReserveSection 23.3 · lesson 99 of 10512 min · free with a free account

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In this lesson

The price of borrowing, and how it reshapes investment plans.

  • Explain what an interest rate is and what sets it
  • Distinguish nominal from real interest rates
  • Show why rate changes hit the marginal project first
  • Trace rate effects on costs, demand, and timing

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Money and the Federal Reserve

Interest Rates and Business Investment

When interest rates rise, headlines often predict that business investment will simply stop. The reality is more precise, and more useful to understand. This is educational content about interest rates and business decisions. It isn't financial, investment, tax, or legal advice. No current interest rates are stated here. Any rate we use is illustrative, constructed for the exercise. A business facing a real financing or investment decision should consult a qualified financial professional. We'll define the interest rate, and look at the components that set it. We'll separate nominal rates from real rates, which is where many comparisons go wrong. Then we'll see why a rate change affects some investments, and leaves others untouched.

Both Sides, One Price

The Price of Borrowing

Start with the basic idea. An interest rate is the price of borrowing. It's expressed as a percentage of the amount borrowed, over a period of time. And it makes sense from both sides of the same transaction. For the lender, it's compensation for giving up the current use of the money. Money that's lent out can't be spent or invested elsewhere, for as long as the loan runs. It's also compensation for risk, the risk that the borrower won't repay in full, or on time. For the borrower, it's the cost of getting funds now, rather than waiting until they're otherwise available. And the borrower weighs that cost against what the money makes possible sooner. So one number captures a trade between two parties, each giving something up.

Table 23.3.1

What a Rate Is Built From

Here's a puzzle. Two businesses borrow the same amount, at the same moment. Why can they face different rates? Because an interest rate is built from several components. The base rate reflects the general cost of funds in the market at that time. Nothing about the particular borrower raises it. It's broad market conditions. The term premium compensates the lender for committing funds over a longer period. A longer commitment means more risk and less flexibility, so asking for a longer repayment period raises it. The credit risk premium reflects this borrower's specific likelihood of default. It draws on the same factors a lender assesses, which we met in the financing chapter. So a weaker credit history, cash flow, or collateral raises it. Finally, the liquidity premium compensates for holding an asset that's hard to turn back into cash before maturity. Borrowing through an instrument with a thin resale market raises that one. The total rate is the sum of whichever components apply. Different rates aren't arbitrary. They have reasons.

Adjusting For Inflation

Nominal Versus Real Rates

Now a distinction that trips up even experienced people. The nominal interest rate is the stated rate, the number written on the loan, unadjusted for inflation. The real interest rate adjusts that for expected inflation. Conceptually, it's the nominal rate minus expected inflation. And it measures something more meaningful, the actual change in purchasing power. It tells you what a lender really gains, and what a borrower really gives up. Here's the crucial consequence, which connects back to our earlier look at inflation. A high nominal rate, in a period of high inflation, may actually be a low real rate. It might even be negative. If inflation runs higher than the nominal rate, the loan can actually favor the borrower.

Worked Comparison

Which Loan Really Costs More?

Let's make that concrete, with figures constructed for the exercise. Loan A carries a nominal rate of eight percent. Expected inflation over the period is six percent. So the real rate is roughly eight minus six, or about two percent. The stated rate sounds high. But the real cost, in purchasing power, is only about two percent. Loan B carries a nominal rate of just four percent, in a period when expected inflation is one percent. Its real rate is roughly four minus one, or about three percent. Now compare them. Loan B's stated rate is half of Loan A's. Yet in real terms, Loan B is the more costly loan. Someone comparing only the nominal rates would reach exactly the wrong conclusion. So whenever you compare borrowing costs across periods, ask what inflation was doing.

The Term Structure

Rates Across Borrowing Periods

Rates also vary with how long you borrow for. That pattern is called the term structure of interest rates. Usually, longer-term borrowing costs more than shorter-term borrowing. That's the term premium at work. A lender committing funds for longer faces more uncertainty about how conditions might change. And the lender gives up flexibility for longer. So it generally asks to be compensated for both. But there are exceptions. Sometimes shorter-term rates are higher than longer-term ones. Historically, that unusual pattern has drawn a lot of attention. It's been watched as a signal in relation to future economic conditions. We'll state the pattern and its exception as facts, without any current rate at any point along the structure.

The Investment Decision

Return Must Beat the Cost of Funds

Now to the heart of the section. How do interest rates shape business investment? A business undertakes an investment when its expected return exceeds the cost of the funds it needs. If the funds are borrowed, that cost is the interest rate. If they're the business's own funds, they still carry an opportunity cost. That money could earn a return elsewhere, the idea behind the cost of capital. This creates a direct link between rates and investment. When rates rise, some investments that were worthwhile stop being worthwhile. Specifically, the ones whose expected return sits between the old, lower rate and the new, higher one. The project closest to the cost of funds is called the marginal project. It's the one a rate change affects first, and most decisively.

Figure 23.3.1

Ranked Projects at 2 Rates

Picture a business with five investment opportunities, ranked from the highest expected return down to the lowest. The exact returns don't matter here. The ranking does. First, suppose the cost of funds is five percent. All five projects clear that bar, so all five are worthwhile. Now suppose the rate rises to nine percent. The top three projects still have expected returns above nine percent. They remain worthwhile. But the bottom two now fall below the new cost of funds. They become unworthwhile. Notice what didn't happen. The rate rise didn't affect all five projects equally. The strongest projects stayed attractive regardless. Only the ones at the margin dropped out. That's why a rate change reshapes a business's investment plan at the edges, rather than eliminating investment altogether.

Present Value

Money Later Is Worth Less Than Money Now

Underneath all this reasoning sits an idea called present value. Money received later is worth less than money received now. The discount rate is the rate used to translate a future amount into its equivalent value today. It reflects the time value of money. A dollar today can be put to work, so a dollar next year is worth less. It also reflects risk, the chance that the future amount never actually arrives. In principle, a project's expected future returns can be discounted back, and compared against its cost today. But we're explaining the mechanism conceptually, not recommending any valuation method. That kind of decision is for a business to work through with qualified financial and accounting professionals. They'll use assumptions suited to the business's own circumstances.

Beyond Investment

Where Else Rates Bite

Interest rates reach well beyond the formal investment decision. They affect the cost of working capital. Financing the funding gap in the cash conversion cycle gets more or less expensive as rates move. They affect the terms available on financing, across every short-term and long-term source. They affect inventory. Stock ties up capital that could otherwise earn the prevailing rate. So higher rates are a reason to hold leaner inventory, all else equal. And they affect the value of existing fixed-rate debt, echoing how bond prices respond to rates. A business that borrowed at a fixed rate before rates rose now holds relatively cheap debt. That's a meaningful advantage, if a largely notional one. Rates reach households too. Higher rates make borrowing costlier, and saving more rewarding. Both tend to reduce current household spending. So a business selling to consumers feels a rate change twice. Once in its own cost of funds, and once in its customers' demand.

Timing And Risk

Lags, and Variable-Rate Borrowing

Two more practical points. The first is timing. A rate change doesn't affect business activity immediately. There's a lag. Businesses don't cancel or approve projects the moment a rate moves. Decisions already in motion continue. New decisions come gradually, as plans are reassessed. And financing renewals come due on their own schedules, not all at once. That lag is a central difficulty for monetary policy, which we'll return to with the Federal Reserve's tools. A policymaker acting today shapes conditions that won't be fully felt for some time. So policy must act on forecasts. The second point is a risk to be aware of, not advice for any particular business. A variable rate moves with market rates over the life of the loan. If rates rise after the loan is taken out, the financing cost rises with them. That can strain a budget, or a project that looked sound at the original rate. So weigh that risk against benefits like a lower initial rate, and discuss it with a financial adviser.

Case Vignette

The Project That Stayed on the List

Basile runs a mid-sized bottling company. This is a composite case, constructed for instruction. He has five expansion projects under consideration. A new product line, a fleet expansion, a second production location, an efficiency upgrade, and a new point-of-sale system. Then his cost of borrowing rises significantly. His first reaction is worry. The whole expansion plan suddenly feels in jeopardy. So he works through the projects one by one, with his financial adviser, ranking them by expected return. Only the two weakest, the new product line and the fleet expansion, become unworthwhile at the higher rate. The other three had expected returns comfortably above even the new rate. They stay on the list. His trade-off was between the emotional weight of the rate rise, and the more precise reality. He can't control the rate. He can only choose which projects to pursue, given it. And the weakest projects, always the most marginal, were exactly the ones a rate rise should affect first. A rate rise reshapes an investment plan at the margin. It doesn't wipe it out. Next, we turn to the institution that most directly shapes those rates, the Federal Reserve System.

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FAQ

Questions students ask us

About Interest Rates and Their Effect on Business Investment

What is the difference between nominal and real interest rates?
The nominal interest rate is the stated rate on a loan, unadjusted for inflation. The real interest rate is roughly the nominal rate minus expected inflation and measures the actual change in purchasing power. For example, an 8 percent loan with 6 percent expected inflation has a real rate of about 2 percent, while a 4 percent loan with 1 percent expected inflation costs about 3 percent in real terms.
Why do different borrowers pay different interest rates?
An interest rate is built from several components. The base rate reflects the general cost of funds in the market. A term premium compensates for lending over a longer period. A credit risk premium reflects the specific borrower's likelihood of default, judged from factors such as credit history, cash flow, and collateral. A liquidity premium compensates for holding an asset that is hard to sell before maturity. The total adds whichever components apply.
How do rising interest rates affect business investment?
A business invests when a project's expected return exceeds its cost of funds, which is the interest rate for borrowed money and an opportunity cost for its own money. When rates rise, projects whose returns fall between the old and new rate stop being worthwhile. If five projects all beat a 5 percent cost of funds but only three beat 9 percent, the two marginal projects drop out while the stronger ones continue.
What is an inverted yield curve?
An inverted yield curve occurs when shorter-term interest rates are higher than longer-term rates, the reverse of the usual term structure of interest rates. Normally, longer borrowing costs more because lenders face more uncertainty and give up flexibility for longer, so they ask for a term premium. Inversions are unusual and have historically been watched closely as a possible signal of weaker economic conditions ahead.

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