BACKGROUND INFORMATION: During the Carter administration, long-term US Treasury yields exceeded 15%, and short-term T-Bills yielded near 20%. After Reagan’s inauguration, interest rates began to fall as Fed Chairman Volcker’s restrictive monetary policy succeeded in containing inflation. Over the past 25 years, US rates have steadily declined: T-Bills are hovering under 1% and the long bond is yielding about 4%.
Lately, though, rising oil prices have incited inflationary forces. China and other developing nations have increased their consumption for oil, metals, materials, and food. Thus, both foreign and domestic factors have spurred demand and are contributing to rising prices on a global scale. In addition to this commodity-induced inflation, US consumers are faced with rising costs for essential services such as healthcare and education.
The Chairman of the Federal Reserve, Ben Bernanke, is faced with a dilemma. Should the Fed increase rates to contain inflation; or, should the Fed keep rates very low to spur the US economy which is beset by a collapse in home values, an extensive banking crisis, and a faltering stock market?
YOUR ASSIGNMENT: Given this economic background…Compose a 3 page report, on the following topic: If the Fed decides to raise interest rates next year, what effect would rising rates have upon the following:
(1) Consumer financing for big-ticket items such as autos and homes;
(2) The present and future values of annuities;
(3) The NPV calculation;
(4) The WACC;
(5) Corporate earnings?
Be sure to illustrate your report with relevant financial numbers. Hint: for topic (3), above, one approach you might adopt is to cite the NPV calculation from the previous case problem, then to contrast it against a new calculation performed with a higher interest rate. Cite the numeric effect upon the NPV, and then explain its rationale and its significance. This is the kind of “numeric illustration” that you should provide for each of the five topic sections.
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