Big Drive Auto is a multistate dealer of several manufacturer’s cars and trucks. Big Drive not only sells the cars but a large part of their business is servicing the autos. This paper will address the managerial decisions that are affected by increasing interest rates and how increasing interest rates affect the cost of operating a business. The current yield curve will be discussed and what this means for Big Drive Auto’s organizational decision making. This paper will analyze how the change in interest rates can change consumer demand. In closing, some other monetary variables, such as durability, government taxes, and capital goods on hand will be explored.
Decisions Affected by Interest Rates
Large decisions, such as long term investments in new dealership sites or new equipment, would be affected by interest rates. According to the Jednak (2005), “Interest rates certainly have an impact on how business owners make management and operational decisions–particularly decisions about long-term investments in new plants and equipment” (¶ 1). Things such as new service equipment or new buildings are considered capital purchases. Capital purchases are those that add equity to Big Drive Auto’s assets. With increasing interest rates the actual price for such projects will be higher than the estimated costs because the higher interest rate will be applied. Introducing a new model to Big Drive’s line of autos is another decision that would be affected by interest rates. If interest rates are high, the demand for cars will decrease. A market of declining demand is not a good time to introduce a new model. In a market with a decreasing or low interest rate the demand for cars with increase. The dollar can buy more in such a market. This is the market in which consumers are willing to try new products.
How Interest Rates Affect the Cost of Operating a Business
Interest rates affect the cost of operating a business in many aspects. If the interest rates are rising, Big Drive Auto must have a higher gross margin to cover the increased fixed expense. Big Drive Auto will have to pass this increase to the consumer. If this was to happen in a market with a decrease in auto sales it could be fatal to Big Drive Auto.
Interest rates have the biggest effect on capital projects. An example of a capital project would be if Big Drive Auto was contemplating the purchase of a new hydraulic lift for one of the service bays. This project would be financed and therefore, be affected by the interest rates. If the interest rates are increasing, Big Drive would pay more for the lift and thereby decrease the amount of equity the lift holds. According to McConnell & Brue (2004), “Investment spending is guided by profit motive; businesses buy capital goods only when they think such purchases will be profitable” (p. 159).
The Yield Curve and the effect of its Shape on the Decision Making in the Organization
The Yield Curve is a graphical representation of the rates of return for short-term to long-term Treasuries. A normal yield curve rises from left to right; this illustrates that long-term bonds command higher interest rates than short-term bills and notes. According to Isidore (2009), “The 10-year yield dipped briefly below the fed funds rate Wednesday morning after a report showed a big drop in demand in April for cars, refrigerators and other big-ticket items known as durable goods” (¶ 6). This inverted yield curve would normally be indicative of an impending recession.
In a recession Big Drive Auto needs to make decisions that will increase their net sales and decrease their overall operations costs; in doing this Big Drive will be able to sell cars at a lower price. According to the Newman (2009) “Most automakers are aggressively cutting production to halt chronic overbuilding…” (¶ 5). Consumers cutback on spending in times of a recession. Being able to price the cars lower will increase Big Drive’s net sales.
Changes in Interest Rates affect Customer Demand
The auto industry relies on their consumers being able to finance the funds needed to purchase the automobile. When interest rates rise, the auto industry is greatly affected. A consumer will shy away from purchasing a new automobile because of the high interest rate that comes with the financing needed. In other words, a higher interest rate will decrease the customer demand.
As interest rates increase so does the requirements for approval of the financing. Therefore, in addition to consumers not wanting to pay a higher interest rate, the consumers willing to pay the higher interest rate may be ineligible for financing. This lack of financing could lead to a decrease in auto sales for Big Drive Auto.
Other Monetary Variables
When making business investment decisions, variables other than interest rate should be considered. Durability of capital goods should be looked at when making decisions. Big Drive Auto needs to assess if they truly need a new hydraulic lift or will the better fiscal decision be getting the old one fixed.
Business taxes also need to be considered when making business investment decisions. An increase in taxes lowers the expected profitability in investment. This shifts the investment demand curve to the left. This shift to the left means the Big Drive will have a decreased rate of return.
Lastly, the amount of capital goods on hand should be considered when making investment decisions. If Big Drive is overstocked with inventory because the demand has decreased for autos, their expected rate of return on new investments will decline. Big Drive would have little incentive to invest in new capital. Therefore, less investment is realized at each real interest rate.
The key decision makers may have previously made decisions that will now be affected by the rising interest rates. The fact that the interest rates are rising means increased production cost for Big Drive Auto. They could pass this increase off to the customer or they can cut production volume. As the interest rates get higher the customer demand will drop. Big Drive Auto should not only use interest rates to base their business investment decisions. They should also use monetary variables, such as taxes, capital goods on hand, and durability, when making investment decisions.
These are rough economic times for Big Drive Auto. Auto sales are down and banks are not lending money. Rising interest rates can spell big trouble for businesses that sell products in which their customers must finance. However, with some thought Big Drive Auto can watch for opportunities and avoid obvious pitfalls.