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- Introduction
- General Overview From the Analysis
- The Level of Short-Term and Long-Term Interest Rates and Its Differences
- Relationship Between Interest Rate and Debt Financing
- Relationship Between Inflation and Debt Financing
- Relationship Between Interest Rate and Company A’s Gearing Ratio
- Relationship Between Interest Rate and Company B’s Gearing Ratio
- Relationship Between Inflation and Company A’s Gearing Ratio
- Relationship Between Inflation and Company B’s Gearing Ratio
- Bibliography
Introduction
Changes in interest rate and inflation affects the debt financing of corporations. Interest rate and debt financing has positive correlation. As interest rate rises, demand for debt falls as cost of capital will increase and growth rate decline. On the other hand, falls in interest rate may cause higher rate of inflation. Therefore, there is a positive relationship between interest rates and inflation. Empirical studies shows when inflation rate is grown up, among several factors rise in interest rate is common phenomenon. Falling in interest rate causes demand for goods, exceed supply, and raise inflation rate as industrial production is going down.
Thus, positive and negative relationship exists between interest rate and inflation. As interest rate changes investor changes the market movement. If money market cannot provide enough return for investors, they will tend to move their fund to capital market. So, new point of equilibrium is established. Therefore, in this way, the debt structure has changed over the period.
General Overview From the Analysis
Netherlands is facing no trouble as growth rate in industrialisation is rising through slight rise in inflation rate. Among various signs, housing sector is in a terrific condition as many of houses are unsold and number of new mortgage approvals has dropped. Consumer confidence level sharply declined. Therefore, the central bank has taken the decision to cut the current Interest rate. The relationship between interest rates is less amount of perfect positive closer relationship. The correlation coefficient is almost 31%-40% in every corner. It indicates, as Interest rate is going down, Netherlands currency is deprecating against USA currency and vice versa.
The R Square means that the variation in the dependent variable has explained by the independent variable. As Interest rate has dropped, people can borrow more money from financial institutions. As a result, the consumption level will increase than existing level.
To meet up the demand, production will increase as manufacturers can boost up money supply by injecting capital. On the other hand, it may not be possible to meet the entire or specific demand. The people and manufacturers will tempt to import goods, raw materials, services from abroad like USA. Consequently, a great portion of foreign reserves would be lessened. As demand for US$ dollar is high and supply is limited a new equilibrium point will be established by deprecating the value of Netherlands currency.
As Interest rate has dropped, depositors from USA will not incline to invest in Netherlands banks reasoning fixed return is lower. They will tend to move their money elsewhere. In these circumstances, the inflow of USA currency and reserve against Netherlands will decline. As EURO has developed, there is less reliability on US currency. In context with demand-supply theory, currency will be deprecated against USA currency. As a result, the debt pattern would be changing.
Though interest rate rose slightly, it has no impact over the debt financing. Arbitrager from USA will buy more Netherlands currency to sell it to another country. It would result huge amount of gain will be occurred and consequently the reserve for Netherlands pound will fall against dollar and EURO. In accordance with interest-rate-parity theorem, if interest rates are lower domestically, the foreign currency will be selling at a discount in the forward market. As a result, overall debt financing will take a new shape.
The Level of Short-Term and Long-Term Interest Rates and Its Differences
Money market holds short-term instruments with short-term interest and short-term liquidity. Capital market holds long-term instruments with long-term interest and long-term liquidity. Risk is low in money market and high in capital market. Changes in bank rate affect both the market. Bank rate is determined through demand and supply of funds. This has explained below:
In market ‘A’ when interest rate falls, money inflow declines and vice versa. If investors assume that interest will fall in near future again, they may shift their funds to Market B where return is 6% with higher liquidity. As, more funds is shifting to Market B, central bank may raise the bank rate to stabilise money supply in Market A and again funds will shift. Thus, interest rate affects the short-term and long-term interest rates and overall debt financing.
If we assume investors are rational, a decrease in interest rates will prompt investors to move money away from the bond market to the equity market in Netherlands. As a result, the debt and equity financing will be changed. The Common money market instruments have included Bankers’ acceptance, commercial paper Certificate of deposit, treasury bills, repurchase agreements, Eurodollar deposit and money market mutual funds. The Capital market’s instruments contained bonds and treasury notes, mortgage, leases, corporate bonds, state and local government bonds as well as preferred and common stocks.
From above approach, it is clear that bank rate cuts will flow the fund towards different sources. As, depositors or investor move their fund to capital market or money market. Mutual funds are corporations that accept money from savers and then use these funds to buy stocks, long term bonds or short term debt instruments. As a result, the corporation debt structure would be changed. If interest rate drops, savers will tend to move their fund to capital market for high liquidity and return. The official bank rate and Netherlands Treasury bill return has smaller positive correlation. It is about.27. Therefore, the changes in Treasury bill return have matched slightly with bank rate.
Relationship Between Interest Rate and Debt Financing
Model Summary.
The relationship between interest rate and debt financing is positively correlated and in a lower degree. It means though the interest rate is rising the demand for loan is not declining. It is happening because the rising in interest rate is low. The gap is moderately small. It is not affecting the cost of capital of the company. So, the company is not reducing the debt financing. The explanatory variable is 38.3% means no significant variability.
Relationship Between Inflation and Debt Financing
Model Summary.
The inflation rate is low. It is not affecting the overall loan status. The rising in inflation rate is not significant as the changes rate is low. So the debt financing is changing its pattern. The following graph shows the trend line of inflation rate over the various years.
Relationship Between Interest Rate and Company A’s Gearing Ratio
Model Summary.
The relationship between interest rate and company A is positively correlated and is not significant. The company is not bother about the rise in interest rates. The rising rate is not significant. So, the interest rate is not affecting the debt structure. The R means variability. No significant variability is occurring. The graph represents everything:
Relationship Between Interest Rate and Company B’s Gearing Ratio
Model Summary.
The R is not quite significant as the gearing ratio variability is not sufficient. Rising in interest rate is only changing the ratio in 23.6% which means the moderate degree of variability. So, investors are not quite concerned. Corporations can use more debt as the cost of capital is changing significantly.
Relationship Between Inflation and Company A’s Gearing Ratio
Model Summary.
The growth rate in inflation is not quite significant as it shows only 38.5% variability. So, investors are not quite concerned about debt financing and corporation can use debt as consumer price index is comparatively low. Inflation is not affecting the loan structure.
Relationship Between Inflation and Company B’s Gearing Ratio
Model Summary.
Company B is moderately affected by the inflation. Most probably it is producing frequent consumable goods. As daily large number of units are selling daily, single inflation can raise the product’s cost and sale price.
Bibliography
Block, B. S. & Hirt, G. A. (2005), Foundations of Financial Management, 11th ed, McGraw-Hill Irwin, Boston. ISBN: 0-07-111096-a.
Besley, S. & Brigham, F. E. (2007), Essentials of Managerial Finance 13th ed., Thomson South-Western, Singapore, ISBN: 0-324-22502.
Bodie, Z. Kane, A. and Marcus A. J. (2005), Investments, 5th Edition, Tata McGraw-hill Publishing Company Limited, New Delhi; ISBN: 0-07-048662-X.
Brigham, E. & F., & Houston, J., (2004), Fundamentals of financial management, 4th edition, ISBN 0-13-040671-6, pp. 117-124.
Kamlet, A. & Carreiro, R. (1997), Stocks – Dividends, The Investment FAQ, Christopher Lott.
Pandey, I. M. (2007), Financial Management, 9th Edition, Vikas Publishing House PVT LTD, New Delhi, ISBN: 81-259-1658-X.
Ross A, Wererfield R, Jaffe J, (2006), Corporate finance, 8th edition, ISBN: 0073105902, McGraw-Hill, pp.853-857.
Institute for the Measurement of Worth (2008), What Was the Interest Rate Then? Web.
Microsoft (2008), MSN Money: Market update. Web.
R. Dave, (1998-2008), How Interest Rates Work. Web.
Raphael Minder, (2008), WORLD NEWS: ADB calls for rise in rates to fight inflation. Web.
Central Bank of Netherlands, (2008), Official Foreign Exchange RATE. Web.
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