US Federal interest rates are more than double the highest recorded rate over the last decade. For those of us tasked with capital project portfolio management and budgeting, these are extremely challenging times. This blog looks at the significant impact that interest rates have on your capital project evaluation and selection.
The Significance of Net Present Value (NPV) in Capital Project Evaluation
Net Present Value (NPV) is the most important financial metric to consider when evaluating and prioritizing candidate projects for inclusion in a capital budget.
Net Present Value Formula
The Net Present Value of a capital project is the sum of all attributable future inflows and outflows discounted at a rate.
The Net Present Value formula, for a project running over (n) periods, should be expressed as follows:
NPV = Cashflow0 + Cashflow1 / (1+discount rate) + Cashflow2 / (1+discount rate)2 + Cashflow3 / (1+discount rate)3 … Cashflown / (1+discount rate)n.
Capital Project Discount Rate for NPV
The capital project discount rate for NPV calculations is made up of two components:
- Time Value of Money
- Adjustment for Portfolio Risk
The basis for the time value of money is typically taken as the risk-free rate of return, such as the return on government bonds.
Interest Rates Directly Impact the NPV Discount Rate
US Federal target interest rates are typically the base rate considered when determining the discount rate to be applied to the projected cashflows of a capital project. Whilst the discount rate also incorporates a risk premium, in general, a doubling of the ‘risk-free’ interest rate will resultantly double the discount rate and affect the evaluation of project outcomes.
The Impact of Doubling the Discount Rate on a Project’s NPV Calculation
In the below example, a series of project cashflows that are strongly positive without discounting is significantly positive at a 5% discount rate; but turns negative at 10%.
Based on a change in interest rates, and the impact that this would have on discount rates, project A in this example should no longer be approved.
Impact of Interest Rate Changes on Project Prioritization
A change in the interest rate will prioritize projects with an earlier return. In the example below, project B produced a lower NPV than project A at a 5% discount rate. Consequently, given a limited capital budget of $100k, project A would have been prioritized. However, at a higher discount rate, project B delivers a positive NPV, and should now be approved.
The net effect of interest rate rises will be to prioritize projects with an accelerated upfront return, over potentially more profitable projects with a longer payback period.
Effect of Interest Rate Increases on Weighted Average Cost of Capital and Project Portfolio
The cost of capital is the return that stakeholders require an organization to deliver. Most organizations are funded by a combination of equity and debt. All of these stakeholders will require the organization to produce returns equal to the risk assumed and the alternative risk-free rate of return. Depending on the debt-to-equity proportion and the nature of an organization’s operations; a weighted average cost of capital can be calculated.
This weighted average cost of capital is set as the hurdle rate that a portfolio of capital projects is required to return. Projects that do not achieve the hurdle rate should be excluded from the capital project portfolio.
Interest Rates Affect the Required Rate of Return
As with the discount rate applied to NPV calculations, an increase in the risk-free rate of return will directly affect the required rate of return by both equity and debt stakeholders.
Interest Rate Increases Affect the Debt-to-Equity Ratio and Weighted Average Cost of Capital
Shareholders need a higher rate of return on invested capital than bondholders because their claims are contingent on profitability and dividend payments. When interest rates increase suddenly, the immediate fall in value of bonds tends to limit the supply of debt finance. Therefore, organizations retain and rely on shareholders’ funds. This rebalancing of the debt-to-equity ratio triggers the calculated weighted average cost of capital to increase.
Rapid Change in Interest Rates Affect the Risk Premium
Instability of financial markets tends to increase the risk premium applied to capital investments. Although stable environmental conditions support long-term capital planning and funding predictability, unstable environments inherently increase project cost and return estimations; increasing the risk of failure. Thereby, a rapidly rising interest rate can have a significant impact on the weighted cost of capital, as higher risk premiums are applied to higher risk-free rates of return.
Capital Interest Calculation
Capital interest incurred on high-value; long-duration projects should be capitalized into the cost of the assets produced. This capital interest must be calculated and included in the overall project budget. As interest rates rise, all capital interest calculations and budget provisions will need to be reviewed and adjusted due to the higher capital interest rate.
The Cost of Inputs
Rising interest rates are associated with high inflation. From the point of view of capital project budgeting, an unstable economic environment is likely to affect both project costs and future returns. There have been extended periods of extremely low inflation over the last decade; therefore, inflationary assumptions were often ignored. In the current economic environment, they can make all the difference to a project’s viability. In addition to increasing the applied discount rate, project estimations should incorporate inflationary increases to capital expenditure (capex) costs, and operating (opex) costs.
The benefits related to capital investments made today can fortunately be inflated. For example, energy cost savings from solar panel installations are likely to be more beneficial in the future as energy prices rise. Additionally, the revenue of new lines of business may be higher than initially estimated due to market price inflation.
The Influence of Foreign Exchange Rates
Exchange rates are heavily influenced by interest rate differentials between economies. Furthermore, risk sensitivity may increase the value of reserve currencies like the US dollar as investors seek safe financial havens. The rate at which individual reserve banks respond to global market conditions is unpredictable and affected by economic and domestic political considerations. For example, Turkey’s politically motivated approach to countering inflation is to reduce interest rates. This is not an effective domestic strategy for Turkey, as it is causing severe impacts to their foreign exchange rate. In contrast, the European Central Bank’s monetary response has been lower and slower, leading to a decline of the Euro across the past year.
In an era of rapidly changing interest rates, significant exchange rate variations can be expected. Capital Budgets will need scrutiny to ensure that these impacts are consistently reflected in the financial metrics applied in the project prioritization.
Contrarian Investment Opportunity
Whilst the traditional approach to rising interest rates suggests a decrease in capital investments, the opportunity exists for brave and competitive organizations to adopt a contrarian view. When your competitors slow down, this may be an excellent opportunity to get ahead. A drop in demand for capital, resources, and technology may be an optimal time to increase your investments. As others relinquish half-built projects, release technical resources, and defer technology investments, the time may be right to seize the initiative and invest.
Interest rates will always have a significant impact on project evaluation, selection, and budgeting. Traditional annual capital budgeting cycles, supported by isolated project evaluation spreadsheets, simply cannot effectively support the capital budgeting challenges of today’s environment.
A modern capital management solution such as Stratex Online will digitally transform your capital budgeting processes by centralizing all data, ensuring the transparency of critical assumptions and parameters, standardizing the calculation of key financial metrics, and automating the prioritization of your project portfolio in response to a changing environment and constraints. By streamlining the workflow around project and portfolio submissions and approvals, the time and effort to recast the project portfolio is reduced. With a more agile and effective project prioritization process, Chief Financial Officers can maximize the return on invested capital and seize on the opportunities presented by unstable economic environments.