Question

Firms will most likely borrow money for investment when (LO6) a) interest rates are low b) interest rates are high c) the interest rate is higher than the expected profit rate d) the expected profit rate is higher than the interest rate

Short answer

Firms will most likely borrow money for investment when the expected profit rate is higher than the interest rate (option d), as this situation allows them to maximize profits and minimize borrowing costs.

Step-by-step solution

Recall the impact of interest rates on borrowing decisions

Low interest rates make it cheaper for firms to borrow money, which increases their willingness to take on investments. High interest rates, on the other hand, make borrowing more expensive, which may discourage firms from investing. The comparison between the interest rate and the expected profit rate is also important, as firms will want to invest in projects that generate profits that are greater than the cost of borrowing.

Analyze Each Option

a) Interest rates are low: Firms might be more likely to borrow money for investment because the cost of borrowing is lower, increasing the potential for their profit to be greater than the interest rate. b) Interest rates are high: Firms might be less likely to borrow money for investment because the cost of borrowing is higher, decreasing the potential for their profit to be greater than the interest rate. c) The interest rate is higher than the expected profit rate: Firms will be less likely to borrow money for investment since the cost of borrowing will be higher than the return they expect to receive from their investment. d) The expected profit rate is higher than the interest rate: Firms will be more likely to borrow money for investment since the return they expect to receive from their investment is greater than the cost of borrowing.

Choose the correct answer

Based on our analysis, we can conclude that firms are most likely to borrow money for investment when option (d) the expected profit rate is higher than the interest rate. This makes sense because firms want to maximize profits and minimize costs, so they will borrow money when the return on investment (profit) is higher than the cost of borrowing (interest rate).

Key concepts

Interest Rates

Interest rates play a pivotal role in deciding whether a firm should borrow money for investment. When interest rates are low, it means the cost of borrowing funds is cheaper. This can encourage firms to invest because they can secure financing at a lowered cost compared to when interest rates are high.
Think of it this way: if the interest rate is like a rental fee for borrowing money, a lower fee makes it more attractive to take this "money rental" for projects. It is particularly beneficial if the anticipated returns of an investment are higher than these borrowing costs. However, when interest rates are high, borrowing becomes costly. Firms may avoid investment because their projects might not generate enough profits to cover the expensive borrowing costs.

Profitability Analysis

Profitability analysis involves evaluating whether an investment will generate returns that can outweigh its costs. In investment decisions, this is simplified to comparing the expected profit rate with the borrowing interest rate.

• If the expected profit rate exceeds the interest rate, the investment is deemed profitable. This means that the firm can cover the cost of borrowing and possess surplus profit.
• If the expected profit rate is less than the interest rate, the cost of borrowing would surpass the benefits gained from the investment, making it unprofitable.

Therefore, sound profitability analysis is crucial because it helps firms determine if taking a loan is a wise decision.
A firm will typically decide to borrow when it can forecast that the profits will comfortably exceed any costs associated with obtaining and servicing the loan.

Borrowing Costs

Borrowing costs are essentially what firms need to pay in terms of interest to use borrowed funds. Understanding these costs is crucial for making sound investment decisions.

• When borrowing costs are low, firms are tempted to seize the opportunity to invest, leveraging cheaper credit to fund their projects.
• High borrowing costs can deter investment, as it raises the financial burden on the firm, and they may end up paying more in interest than they could hope to earn back in profits on their investment.

When a firm contemplates an investment, they must consider these costs carefully. The idea is to ensure that any interest paid does not eat into the expected profits from the project. By evaluating borrowing costs alongside interest rates and expected returns, a firm can better decide on the financial viability of a potential investment.