Profit before interest & tax ÷ Capital employed × 100
Measures efficiency of capital use.
5.5 Mini data‑set – interest expense
ABC Ltd has a £500,000 bank loan:
Scenario
Interest rate
Annual interest expense (£)
Before change
6 %
30,000
After a 2 % rise
8 %
40,000
Question (AO2/AO3): Calculate the percentage increase in the annual interest expense and discuss how this might affect ABC Ltd’s pricing strategy.
6. External Influences – Government Policy: Changes in Interest Rates
6.1 What are interest rates and why does the government use them?
Definition: The cost of borrowing money, expressed as a percentage of the amount borrowed. In the UK the Bank of England (BoE) sets the base rate, which influences the rates commercial banks charge.
Key government economic objectives (Cambridge syllabus 1.6.2)
Control inflation.
Stimulate economic growth.
Stabilise employment.
Influence the exchange rate.
Why the central bank changes rates
Curb inflation: Raising rates makes credit more expensive, reducing consumer spending and price‑rise pressures.
Manage exchange rate: Higher domestic rates attract foreign capital, causing the currency to appreciate.
6.2 Direct effects on businesses
Cost of finance
Higher rates → higher interest repayments → lower profit margins for firms that rely on borrowing.
Typical responses: renegotiate loan terms, switch to cheaper finance, delay new borrowing.
Investment decisions
Higher rates raise the required rate of return (the “hurdle rate”). Fewer projects meet the profitability test.
NPV formula (AO2/AO3):
$$\text{NPV}= \sum_{t=1}^{n}\frac{C_{t}}{(1+r)^{t}}-C_{0}$$
where r = discount (interest) rate.
Worked example (simple three‑year project):
Year
Cash inflow (£)
0 (initial outlay)
-10,000
1
4,000
2
4,000
3
4,000
Using a discount rate of 5 %:
NPV = 4,000/1.05 + 4,000/1.05² + 4,000/1.05³ – 10,000 = £1,150 (positive – project acceptable).
Using a discount rate of 10 %:
NPV = 4,000/1.10 + 4,000/1.10² + 4,000/1.10³ – 10,000 = –£210 (negative – project rejected).
This shows how a rise in interest rates can turn a viable investment into an unviable one.
Typical business response: postpone or cancel capital projects, seek internal funding, or look for higher‑return opportunities.
Cash‑flow management
Higher interest payments tighten cash flow, limiting ability to pay suppliers, hold inventory, or meet dividend expectations.
Typical response: tighten credit control on customers, reduce stock levels, negotiate longer payment terms with suppliers.
6.3 Indirect effects on the wider economy (and implications for businesses)
Consumer spending
Higher rates increase mortgage, credit‑card and personal‑loan repayments → disposable income falls → demand for non‑essential goods falls.
Business implication: retailers may lower prices or run promotions; manufacturers may cut output.
Exchange rate
Higher domestic rates attract foreign capital → domestic currency appreciates.
Result: exports become more expensive, imports cheaper.
Business implication: export‑oriented firms may see lower sales and consider off‑shoring or hedging; import‑dependent firms benefit from lower input costs.
Lower rates have the opposite effect, potentially fuelling inflation.
Business implication: slower input‑cost growth helps margins; higher inflation may force price rises, risking market share.
Employment
Reduced demand can lead to lower production → redundancies or slower hiring.
Higher employment supports consumer spending, creating a feedback loop.
Business implication: firms may adopt flexible working, up‑skill staff, or delay recruitment.
6.4 Summary table – Effects of an increase vs. a decrease in interest rates
Effect
Increase in Interest Rates
Decrease in Interest Rates
Cost of borrowing for businesses
Higher – profit margins fall
Lower – profit margins improve
Consumer spending
Falls – higher loan repayments
Rises – cheaper credit
Investment in plant & equipment
Falls – higher hurdle rate (NPV less likely positive)
Rises – lower hurdle rate
Exchange rate (ceteris paribus)
Appreciates – exports less competitive
Depreciates – imports more expensive
Inflationary pressure
Reduced – demand slows
Increased – demand rises
Unemployment
May rise – lower output
May fall – higher output
6.5 Short‑term vs. long‑term considerations
Short‑term: Immediate impact on borrowing costs influences consumer confidence, house‑price activity and cash‑flow of firms with variable‑rate loans.
Long‑term: Persistent low rates can boost capital formation, raise productivity and expand potential output; prolonged high rates may suppress investment, slow technological progress and increase structural unemployment.
6.6 Evaluation prompt (AO4)
Weigh the short‑term benefit of reduced inflation against the longer‑term risk of higher unemployment. Which outcome is likely to be a higher priority for a developing economy that is still trying to create jobs? Provide a justified recommendation for a manufacturing firm that is considering a £2 million expansion project.
6.7 Potential exam questions (AO2‑AO4)
Explain how an increase in interest rates can affect a manufacturing firm’s decision to expand its production capacity.
Discuss the likely impact on a country’s export market if the central bank raises interest rates.
Using a diagram, illustrate the effect of a change in interest rates on the aggregate‑demand curve.
Evaluate the advantages and disadvantages of using interest‑rate policy to control inflation in a country with high unemployment.
Suggested diagram: Aggregate‑demand shift caused by a change in interest rates (AD₁ → AD₂).
Your generous donation helps us continue providing free Cambridge IGCSE & A-Level resources,
past papers, syllabus notes, revision questions, and high-quality online tutoring to students across Kenya.