Question

If a firm is considering using its own funds (rather than borrowing) to finance investment projects, will higher interest rates discourage the firm from undertaking these projects? Explain. (Hint: Think of yourself as the owner of a firm that has earned profits and imagine that you are going to use the profits either to finance new investment projects or to buy bonds. Will your decision to invest in new projects in your firm be affected by the interest rate?)

Answer 1

Answer:

A higher interest rate will discourage the firm from undertaking the projects, as higher interest rate will increase the required return or IRR of the project, the reason for this is that as interest rates increase the opportunity cost of investing in the project increases because with higher interest rates the firm can earn a higher risk free return from government bonds then before and this discourages the firm from investing in a project.

Explanation: