Question

Answer the question on the basis of the following information. Assume that if the interest rate that businesses must pay to borrow funds were 20 percent. It would be unprofitable for businesses to invest in new machinery and equipment, so investment would be zero. But if the interest rate were 16 percent, businesses would find it profitable to invest $10 billion. If the interest rate were 12 percent. $20 billion would be invested. Assume that total investment continues to increase by $10 billion for each successive 4 percentage point decline in the interest rate. Refer to the information. Which of the following is an accurate verbal statement of the described relationship?
a. There is no regular or dependable relationship between business investment and the interest rate
b. The amount of business investment is unaffected by changes in the interest rate
c. Investment spending by businesses varies inversely with the interest rate.
d. Investment spending by businesses varies directly with the interest rate.

Answer 1

Answer:

The answer is: C) Investment spending by businesses varies inversely with the interest rate.

Explanation:

This statement is true all the time. When a company evaluates the costs and benefits of an investment, interest rate plays a fundamental part in those calculations. The two basic reasons for that are:

1. The higher the interest rate a company (or any individual) has to pay for a loan, the harder it is for the company to repay the loan.
2. The interest rate a bank charges is usually correlated to the opportunity cost of an investment. The higher the interest rates banks charge, the higher the internal rate of return (which is used to calculate the Net Present Value of an investment) will be. This is because banks don´t print money, they take in deposits and then they loan the money the someone else. So if the interest rate the bank charges is high, usually the interest rates the bank pays for the deposits is also high. Instead of investing, a company might just put their money on the bank and earn a better return rate.