InstructionsRead the scenario below, and answer the following questions.You work as a financial analyst at a large automobile corporation that occasionally makes acquisitions of smaller companies that specialize in the production and assembly of small component parts. In order to achieve vertical integration of its newest sports sedan model, the company is evaluating a few manufacturing companies that have experienced strong financial performance in the past few years. These companies would make excellent acquisitions due to the nature and quality of the product and the anticipated ease of transition. You have been tasked to evaluate these companies from a financial perspective and choose one. To do this, you need to brush up on a few concepts by addressing the following topics:Describe what a crediting rate/score is. Should this be a factor in evaluating companies?The firm will need to raise funds immediately for the acquisition, and debt will be used. Should the firm borrow on a long-term or short-term basis? Why?Explain the effect, if any, inflation rates will have on the purchase? How significant is this factor?Define the relationship between yield curves and the term structure of interest rates.Explain what would happen to interest rates if a new process was developed that allowed automobiles to run off oil that was formulated based on lemonade? The technology used to convert this liquid to gas would be pricey but well worth it. What impact would this technology have on interest rates?Discuss what ratios should be used to assess the financial health of the potential acquisition?Your completed case study must be at least two pages in length, and you must use at least your textbook as a reference. Other references may be used as needed. Any information from a source used must be cited and referenced in APA format.
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UNIT III STUDY GUIDE
Monetary Systems and Interest Rates
Course Learning Outcomes for Unit III
Upon completion of this unit, students should be able to:
1. Explain foundational finance theories.
1.1 Explore the concepts of crediting rates, inflation rates, and types of debt as related to a
business scenario.
2. Analyze a financial forecast using relevant data.
2.1 Define the relationship between yield curves and the structure of interest rates.
5. Prepare preliminary financial statements and ratio analyses.
5.1 Discuss the ratios necessary for the assessment of the financial health of a business.
Course/Unit
Learning Outcomes
1.1
2.1
5.1
Learning Activity
Unit Lesson
Chapter 7
Chapter 8
Unit III Case Study
Unit Lesson
Chapter 8
Unit III Case Study
Unit Lesson
Chapter 8
Unit III Case Study
Required Unit Resources
Chapter 7: Money and the Monetary System
Chapter 8: Interest Rates
Unit Lesson
During this unit, we will examine the savings and investment process and interest rates. We will examine the
major components of the gross domestic product (GDP), we will explore the factors that impact savings, and
we will look at the main sources of savings. Further, we will evaluate the types of capital market securities that
assist the savings and investment process. Finally, we will briefly touch on mortgage loans and how the
mortgage markets enable home ownership.
GDP, Capital Formation, and Sources of Savings
In theory, the monetary policy adopted by the Federal Reserve has an effect on the rate of GDP growth. An
expansive monetary policy characterized by low interest rates during periods of recession is intended to
stimulate economic activity and growth. A restrictive monetary policy characterized by higher interest rates is
intended to reduce economic activity and control inflation. Research examining the effect of monetary policy
on GDP, however, has determined that the effect on GDP is more significant during periods of expansion and
inflation than during recession (Tenreyro & Thwaites, 2016). In effect, monetary policy alone may not be a
sufficient stimulus to raise GDP during a recession.
BBA 3301, Financial Management
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GDP is composed of four elements:
personal consumption expenditures,
government expenditures that include
investment, private domestic investment,
and net exports of goods and services.
Gross private domestic investment is the
source of capital to support business
activity on which the economy depends
(Melicher & Norton, 2013). A link exists
between savings and investment with the
amount of available savings determining
the amount of investment. Savings
requires excess funding that is not
necessary for immediate consumption and
is therefore set aside for future consumption
or investment. Investment involves the
purchase of assets that can be used to
generate future production.
UNIT x STUDY GUIDE
Personal
Consumption
Expenditures
Title
Government
Expenditures
Four
Elements of
GDP
Private
Domestic
Investment
Net Exports
of Goods
and Services
Private savings is a major source of savings for capital formation. Undistributed corporate profit is generally
the largest source of savings in the U.S. with corporations holding the profits for later use. The undistributed
corporate profit is adjusted by inventory valuations with an investment in inventory not considered
undistributed profits (Chen, Karabarbounis, & Neiman, 2017). Personal savings are the next largest source of
savings. Government sources of savings are collected revenues that are not spent. The amount of federal
deficit is so high that the net savings for the United States is generally negative.
From the early 1970s through the end of the 1990s, the U.S. government functioned with an annual budget
deficit. While the surplus budgets of the next four years were realized due to more efficient budgeting and
forecasting, the deficit quickly started growing in 2002. For instance, during the fiscal years 2009-2012, the
budget deficits surpassed $1 trillion annually (Amadeo, 2019). The U.S. National Debt Clock shows the actual
debt figures in a real-time mode. The site not only illustrates the debt figures, but it also highlights tax
revenues, unemployment figures, and both state and world debt totals.
Supply and Demand for Loanable Funds
The Federal Reserve uses interest rates as the means to control the rate of growth of the money supply in the
United States (Palley, 2015). In theory, interest rates help protect the economy from recession by accelerating
the growth of the money supply with lower interest rates and protect the economy from inflation by
decelerating the growth of the money supply with higher interest rates.
The Federal Reserve has various other tools to implement monetary policy. The Federal Reserve can raise or
lower the discount rate, which is the amount charged to member banks to borrow from the Federal Reserve to
maintain the amount of required reserve. The Federal Reserve can also change the reserve requirements for
banks, which can influence the amount of funds the bank can use to make loans to customers. Another
method the Federal Reserve uses to manage interest rates is the purchase and sale of treasury debt; the sale
reduces the amount of money in circulation to increase interest rates while the purchase increases the
amount of money in circulation.
Interest rates influence the supply and demand for loanable funds with supply and demand in equilibrium at
the current interest rate. If the interest rate increases, the demand for loanable funds will decrease because
the loan becomes more expensive at the higher interest rate. In effect, the demand curve shifts to the right.
At the same time, the supply of loanable funds will increase because lenders can obtain a higher return,
shifting the supply curve to the left. A new equilibrium is established with more supply but less demand
(Arnold, 2010).
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Capital Market Securities
UNIT x STUDY GUIDE
Title
There are two types of financial markets that can be utilized for investing: money markets and capital
markets. The difference is based on the time frame of the markets. For instance, money markets issue and
trade debt securities of one year or less. Alternatively, capital markets issue and trade debt securities with a
maturity longer than a year. See below for a table that breaks down the type of security and a short
explanation of each (Anspach, 2018). These securities could also be evaluated based on level of risk; in this
case, the treasury bonds would be the least risky based on their stable terms.
Security
Mortgage
Description
Backed by real property in the form of buildings
and houses. Typical maturities are 5 to 30 years.
Treasury note/bond
Debt instrument issued by the U.S. federal
government. Typical maturities are 2 to 30 years.
Municipal bond
Debt instrument issued by a state or local
government. Typical maturities are 2 to 40 years.
Corporate bond
Debt instrument issued by a corporation to raise
long-term funds. Typical maturities are 2 to 30
years.
Common stock
Security that indicates ownership interest in a
corporation. There are no maturities on common
stocks.
Market Interest Rates
Market interest rates differ from nominal interest rates because of the compensation that a lender requires
reflecting the opportunity costs and the risks associated with a loan. By making a loan for a fixed period, the
lender forgoes other opportunities that may arise with a premium above nominal interest rates compensating
the lender (Melicher & Norton, 2013).
Inflation is a component of the market interest rate because of the likelihood that the value of the principal will
erode over time because of inflation. Default risk is also a component of the market interest rate with the
premium varying based on the creditworthiness of the borrower. Maturity risk can increase the interest rate for
longer-term loans because of the difficulty of forecasting long-term events such as future interest rates.
Liquidity risk is an additional premium added to loans that cannot be easily converted into cash in a
secondary market.
Inflation Premiums and Price Movements
The inflation premium reflects the amount of anticipated inflation over the life of the loan. The inflation
premium is intended to compensate the lender for the loss of purchasing power from inflation. In effect, the
lender bears the risk that actual inflation will be higher than anticipated at the time the loan is made while the
borrower bears the risk that the inflation will be lower than anticipated at the time the loan is made. Inflation
can have a significant effect on price movements because interest rates in periods of very high inflation can
be substantial. As the inflation increases, the market value of existing loans decreases because of the higher
inflation premiums lenders demand to compensate for inflation.
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At times, the price levelUNIT
can xincrease
STUDYwithout
GUIDEany
change in the overall money
Title supply if costs outpace
productivity. Individuals will feel the impact first-hand
in the form of higher prices. Known as cost-push
inflation, the costs, not the money supply, is the cause
of the increased prices. These types of inflation are
not mutually exclusive and are present at the same
time.
Another type of inflation, speculative inflation, occurs
as a result of an increased money supply. If prices
have been rising for a while, then it is assumed they
will continue to increase. Instead of these higher
prices creating a decrease in demand, the opposite
Inflation greatly impacts financial management.
occurs. Thus, instead of product demand decreasing
(Tolibov, 2018)
due to higher prices, we see an increase in demand
as consumers fear for the worst and would prefer to stock up on the goods. As consumers, it is important to
be able to distinguish between the hype and the necessity and/or utility of the good/service.
During the 1950s through the 1970s, high levels of inflation persisted. Many people considered this
phenomenon to be a long-run inflationary bias. Wages tend to increase during periods of rapid growth and
economic expansion. The U.S. government is tasked with reducing unemployment, which not only
strengthens the economy but enables the wages to stabilize more consistently over time.
In summary, we examined the basic functions of GDP and how it serves as a forecasting tool for future action.
We evaluated the impact of interest rates on markets and funds/savings. Further, we touched on inflation and
price movements and how they interact with changes in the markets. Finally, we wrapped up the lesson by
assessing the role of government on inflation.
References
Amadeo, K. (2019). Current U.S. federal budget deficit. Retrieved from https://www.thebalance.com/current-us-federal-budget-deficit-3305783
Anspach, D. (2018). Three types of securities investments. Retrieved from https://www.thebalance.com/whatare-securities-2388638
Arnold, R. (2010). Macroeconomics. Mason OH: South-Western Cengage.
Chen, P., Karabarbounis, L., & Neiman, P. (2017). The global rise of corporate saving. Journal of Monetary
Economics, 89, 1-19.
Melicher, R., & Norton, E. (2013). Introduction to finance. Hoboken NJ: Wiley.
Palley, T. (2015). Money, fiscal policy, and interest rates: A critique of modern monetary theory. Review of
Political Economy, 27(1), 1-23.
Tenreyro, S., & Thwaites, G. (2016). Pushing on a string: U.S. monetary policy is less powerful in recessions.
American Economic Journal: Macroeconomics, 8(4), 43-74.
Tolibov, G. (2018). ID 110219625 [Image]. Retrieved from https://www.dreamstime.com/inflation-chartblackboard-growth-inflation-chart-word-inflation-board-image110219625
BBA 3301, Financial Management
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Suggested Unit Resources
UNIT x STUDY GUIDE
Title
In order to access the following resources, click the links below.
In this unit, you were introduced to monetary systems. The video below further explores that topic and briefly
explains the three main types of monetary systems.
The Duomo Initiative. (2017). What is a monetary system? [Video file]. Retrieved from
Learning Activities (Nongraded)
Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit
them. If you have questions, contact your instructor for further guidance and information.
How well do you know the unit material? Take the Unit III Knowledge Check Quiz to find out!
BBA 3301, Financial Management
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