Faculty corner, Low Interest Rates Create Wealth

Today "Wealth" is the most discussed topic in the management literature, it may be either wealth creation or wealth erosion, but wealth is always prominently mentioned in today's management literature. In common man language it is equivalent to "Profits". Today people understand it in terms of share price that if share prices are increasing wealth is created and if it falls then wealth is eroded. (Unfortunately today every single second wealth is created and eroded in stock markets because of some other reasons) Financially, wealth creation means adding higher value (in terms of money) to the firm than the cost of resources of the firm. The entire process is evaluated on the basis of "Time Value Principle".

Let's understand the concept of "Time Value of Money". Financial authorities explain it in very simple terms like one rupee of today is more valuable than one rupee of tomorrow. It actually means given a choice anybody will prefer to receive one rupee today than receiving it tomorrow. Two points supports this concept.

Firstly, anyone gets a rupee today he can put it in a bank and get interest on it. Secondly, if anybody spends that rupee today then he gets more goods in one rupee as compared to the number of goods he will get if he prefers to spend that one rupee a day later. The implicit assumption behind the second point is that most economies have inflation, means prices of goods and services increases with time.

Time value of Money concept is the fundamental concept behind the "Present Value of Money". Present Value of Money is calculated for knowing the viability of wealth creation. This exercise in finance is known as IMA chrysalis may 2008 edition 14
"Capital Budgeting" exercise. Simply put if anyone makes an investment today and receives benefits in future over a number of years, then the benefit received in future should be more than the cost of the investment, then we say that investment is viable or wealth is being created.

Investment done is denominated in terms of money invested and benefits received are also denominated in terms of money received. Since we know that money received today is better than the money received a year later, we compare today's money with the money received in future by taking present value of future money. To know present value of future money principle of discounting is applied. As today's money is higher in value than future money therefore future money is discounted by a discount factor, which will make future money comparable to today's money. Let's see how it is practically done.

Suppose we invest Rs.10 crores today and our time horizon is 3 years. In I year we get Rs.3 crore, in II year we get another Rs.6 crore and in III year we get Rs.3 crore as benefits. For the time being just takes into consideration that discount factor is 10%. Therefore; 10 = 3 / (1.1) + 6 / (1.1) 2 + 3 (1.1) 3 = 9.94 (approx.)

This means that even though the investment of Rs.10 crore gives total benefits of Rs.12 crore over a period of three years but when this Rs.12 crore is compared in their present value, then this is only Rs.9.94 crore which is less than Rs.10 crore. Conclusion drawn is that this investment is eroding wealth and therefore not desirable.

The important point to consider here is that we took a discount factor of 10%; instead of that now we take a discount factor of 9% and see the calculations. 10 = 3 / (1.09) + 6 / (1.09) 2 + 3 (1.09)2 = 10.12 (approx.)
This means that investment of Rs.10 crore gives total benefits of Rs.12 crore over a period of three years and a benefit of Rs.10.12 crore when compared in their present value, which is more than Rs.10 crore. Conclusion drawn is that this investment is creating wealth and therefore desirable.

It seems strange that by changing just one mathematical number (discount factor) in our example, we have turn- around a wealth eroding investment to a wealth-creating proposition. (In actual it is not so easy to do that) Point, which I would like to emphasize here, is that the discount factor plays a very important role in wealth creating process. The obvious question is what this discount factor means?
As I have already mentioned earlier that wealth is created when benefits received (in money terms) is more than the cost of resources. As we all know that many resources are utilised like man, machine, materials, minutes, etc. but all these resources can be converted into one common resource for simple understanding and for comparison purpose that is money. Therefore going by definition, the cost of money should be less that the total money received in future to create wealth. This cost of money is defined as 'Cost of Capital" in financial terms and is the "Discounting factor" in our example.

After understanding the discount factor, next question is how to know the cost of money. Money (cash) utilised for investment purpose can be generated from IMA chrysalis may 2008 edition 15
two ways: Equity capital and Debt capital. If we can calculate the cost of both type of capital and add them in their weight ages then we can get total cost of money, which is also known as "Weighted Average Cost of Capital" (WACC) in finance language. Cost of equity is calculated be certain formulas under different assumptions, for our purpose we can say that it is fixed. Now the cost of debt capital is the interest paid on the borrowed money. So if Rs.100 is borrowed at 5% interest p.a. cost of debt is 5%.
Assuming that the cost of equity is fixed (in practice it changes more frequently) which is 10% in our example and Rs. 5 crore is the equity capital and another Rs. 5 crore is debt capital at the cost of 10% then WACC comes 10% for the investment. Now if the cost of equity is fixed at 10% and the WACC comes to 9%, which means cost of debt, have been reduced to 8% from 10%. Thus the reduction in interest rate reduces the cost of debt that makes project a wealth-creating proposition. Thus financially it is proven that the reduction in interest creates wealth. With reduction of interest rates, many projects, which are marginal cases in the economy where even a reduction of 500 basis points will prove them viable, will start and thus the entire economy will see a swing in its investment activities.

In the above example we reduced the cost of debt and kept the cost of equity fixed, but why can't we reduce the cost of equity and have fixed cost of debt thus maintaining the same interest rates in the economy. If we consider the reduction in equity rate that means we are reducing the returns generated on equity capital that will ultimately lead to the less investments and therefore less probability of wealth creation. Secondly, equity returns are the motivating factors for entrepreneurship; it's the high return that prompts people to take risk. Equity returns are also not centrally controlled just like interest rates where central bank of any country plays a major role; it depends upon individual promoter or firm's expectations, which may vary. Thus we see that low interest rates help the process of wealth creation in the economy, as people are ready to take high risk for high equity returns.
- S.Srinivasa (Faculty Accounts)