Question Tag: Interest rates

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  • 10 Marks

AFM – Nov 2018 – L3 – Q5a – The role of the treasury function in multinationals

Determine whether GCB should borrow locally or through a portfolio of foreign currencies based on borrowing rates and expected currency changes.

The Ghana Cocoa Board (GCB) is contemplating borrowing one-year funds in anticipation of the coming cocoa season, which starts in September/October 2017. GCB can borrow from the local financial market in Ghana or borrow a portfolio of funds made up of UK pounds and Euros. The information below is the borrowing rates and the probabilities of expected strengthening of the international currencies vis-à-vis the cedi.

Required:
Determine whether GCB should borrow from the local financial market or borrow a portfolio of funds made up of UK pounds and Euros.

To determine the best borrowing option, we need to compare the effective borrowing rates from both options. First, we calculate the expected strengthening rates for both the UK pounds and Euros.

Since the portfolio borrowing rate of 6.62% is significantly lower than the local borrowing rate of 18%, GCB should borrow the portfolio of funds made up of UK pounds and Euros.

Conclusion:
GCB should opt for borrowing the portfolio of UK pounds and Euros due to the lower effective borrowing rate compared to the local borrowing rate in Ghana Cedis.

  • 9 Marks

AFM – Nov 2017 – L3 – Q1a – Role and Responsibility towards Stakeholders

Explains two reasons why interest rates rise in periods of inflation and discuss the implications of high or fluctuating interest rates on business financing and asset-holding decisions.

Under conditions of inflation, it is common for interest rates to rise possibly at a rate different from those applicable to goods and services.

Required:
i) Explain TWO possible reasons for this phenomenon.

(3 marks)

ii)

Discuss the implications of high or fluctuating interest rates for:

  • Business financing; and (3 marks)
  • Assets-holding decisions. (3 marks)

(Give examples of the types of actions that a company might take)

i)

  • Because of Government monetary policy. Interest rates may be increased to reduce the flow of money in the economy.
  • Because of Government exchange control policy. If inflation is making it more difficult to export and encouraging an increase in imports, the government may intervene by raising domestic interest rates. This would encourage a flow of foreign investment into the domestic market and improve the exchange rate.
  • Because of a reduced propensity to save, at a time when inflation is eroding the value of any funds not consumed immediately. This could lead banks and other financial institutions to raise their interest rates to attract more deposits.

ii)

Implications on Business Financing:

  • High or fluctuating interest rates make it difficult to obtain funds. Companies will be reluctant to raise fixed-interest borrowing if they fear that interest rates will fall. Overdraft finance will also be expensive but preferable as the interest rate is not fixed.
  • They may cause liquidity problems, making business operations difficult throughout the economy. Debtors may delay payments, and creditors will increase pressure for quick settlements.
  • It complicates planning and budgeting, as cash flow becomes uncertain and interest charges vary with fluctuations in interest rates, reducing available liquid funds.

Implications on Asset-Holding Decisions:

  • Liquidity problems will force companies to scrutinize their current assets. This could involve reducing buffer stocks, tightening credit terms, and realizing investments.
  • The difficulty in securing long-term finance could prevent replacing fixed assets or necessitate selling fixed assets to generate liquid funds.
  • 4 Marks

TX – May 2019 – L3 – Q1e – International Taxation

Evaluate the negative consequences of public debt on the economy of Ghana.

Public debt is an important source of revenue for a government to finance public spending where taxation capacity may be limited, or when the alternative would be to print money and compromise macroeconomic stability. There are, however, negative consequences of high public debt on the economy.

Required:

Evaluate FOUR (4) of such negative consequences of public debt on the economy of Ghana.
(4 marks)

  • Tax Burden: Higher public debt results in the need to impose additional taxes to service the debt, which can reduce incentives to work and save. This tax burden can also lead to income redistribution from the poor to the rich, as bondholders (often wealthier individuals) receive interest payments funded by taxes.
  • Higher Interest Rates: Increased public debt can lead to higher interest rates as the government competes with the private sector for borrowed funds. This makes borrowing more expensive for everyone, stifling private investment and economic growth.
  • Stifling Economic Growth: Public debt diverts capital from the private sector to the public sector, reducing the funds available for productive investment. This can slow down economic growth and lower the overall standard of living.
  • Negative Impact on Long-Term Investment: High public debt can discourage long-term investment due to the uncertainty it creates. Investors may demand higher returns to compensate for the perceived risk, leading to higher long-term interest rates and further slowing economic growth.
  • 20 Marks

FM – MAY 2018 – L2 – Q1 – Economic and regulatory environment

Discusses the effects of high interest rates on the economy, explores the agency problem, and explains why share price maximization is preferred to sales maximization.

a) Economist has always maintained that to increase inflation, the government ought to implement a policy of high interest rate to dampen demand.

Required:
Identify the effects on the economy of a policy of high interest rate on expenditure and investments.

b) Agency problem is pervasive and exists in practically every organization whether a business, church, club, or government. Organizations try to solve it by instituting measures but no organization can remedy it completely.

Required:
i) What is the agency problem within the context of a limited liability company?

ii) Explain TWO causes of the agency problem.
(2 marks)

iii) Explain FOUR remedies to the agency problem.
(4 marks)

c) For a business, it is not necessary that profit should be the only objective; it may concentrate on various aspects such as maximization of share price, maximization of sales, capturing more market shares, return on capital employed among others, which will take care of profitability.

Required:
Explain why maximization of a company’s share price is preferred as a financial objective to maximization of its sales.
(6 marks)

a) Effects on the economy of a policy of high interest rate:

  1. Reduces borrowing:
    High interest rates make borrowing more expensive for businesses and consumers, leading to a reduction in overall demand for loans.
  2. Decreases investment:
    Businesses are likely to cut back on investment in new projects due to the higher cost of borrowing, which can slow down economic growth.
  3. Encourages savings:
    Higher interest rates incentivize saving as people earn more from their savings, reducing consumer spending.
  4. Reduces disposable income:
    For those with variable-rate loans, higher interest rates mean higher loan payments, reducing the amount of disposable income available for spending.
  5. Discourages inflation:
    By dampening demand, higher interest rates can help control inflationary pressures within the economy.

 

b) i) Agency problem within a limited liability company:

The agency problem refers to a conflict of interest where company management (agents) may act in their own interests rather than in the best interests of the shareholders (principals). This can lead to decisions that do not maximize shareholder value.

ii) Causes of the agency problem:

  1. Divergence of interests:
    Managers may prioritize personal benefits such as job security, higher compensation, or perks over the goal of maximizing shareholder value.
  2. Risk aversion:
    Managers may avoid risky but potentially profitable investments because they fear the consequences of failure, even though shareholders may prefer higher-risk, higher-reward projects.

 

iii) Remedies to the agency problem:

  1. Managerial compensation:
    Aligning managers’ incentives with shareholders’ interests through performance-based compensation, such as bonuses or stock options, can motivate managers to work towards maximizing shareholder value.
  2. Shareholder control:
    Shareholders can exert influence over management decisions through voting rights and active participation in annual general meetings.
  3. Threat of dismissal:
    The possibility of being fired for poor performance can incentivize managers to align their actions with shareholders’ interests.
  4. Threat of takeovers:
    The potential for a takeover, where underperforming managers may be replaced, serves as an external control mechanism ensuring management acts in the best interest of shareholders.

 

c) Why share price maximization is preferred to sales maximization:

  1. Focus on profitability:
    Share price maximization inherently considers profitability, whereas sales maximization may prioritize revenue without considering the costs involved.
  2. Reflects market value:
    Maximizing share price aligns with increasing the overall market value of the firm, benefiting shareholders directly.
  3. Incorporates risk:
    Share price maximization takes into account the risks associated with business decisions, unlike sales maximization, which may overlook potential downsides.
  4. Long-term growth:
    A focus on share price encourages long-term strategic decisions that support sustained growth and stability, rather than short-term sales spikes.

 

  • 9 Marks

FM – MAY 2019 – L2 – Q5a – Cost of capital

Calculate the price investors would be willing to pay for a bond and explain how changes in interest rates affect bond values.

Anape Ltd is considering issuing a new 10-year bond in the domestic market. The interest rate on the bond is 20%. Interest will be paid semi-annually. The directors are considering the appropriate price at which the new bonds should be sold. The market required return is 25%.

Required:

  1. Compute the price investors would be willing to pay for each GH¢100 face value bond. (5 marks)
  2. Explain how changes in average interest rate affect the value of bonds. (4 marks)

(Total: 9 marks)

i) Price investors would be willing to pay
Face value= GH¢ 100
Coupon rate = 20%, paid semi-annually
Required return= 25%

 

ii) There is an inverse relationship between interest rates and price of bonds. As
interest rates rise, bond prices drop. Conversely, as interest rates decline, bond
prices rise. Interest rate movements reflect the value of money or safety of
investment at a given time. The movement of interest rates affects the price of
bonds because the coupon rate of interest, the money the issuer pays semi-annually to the owners of its bonds, remains fixed until the bond matures and
pays the GH¢1,000 principal. The fixed semi-annual interest payments and the
fixed repayment of principal at maturity are why bonds are called fixed income
investments.

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