This is a report on the impact of a tax rate increase on an organization with a loan portfolio of £ 6.5million. The increase of interest rate by 0.5% will increase the interest expense and therefore have an effect on the cash flows of the company. Any manager must therefore scan the environment and look into the ways in which such shocks will be absorbed by the business.
O’Sullivan and Steven (2003) argue that Interest is the price period for money that is borrowed. It is the consideration paid for the cost forgone for current consumption (p. 458). In England the interest rates is determined by the banks monetary policy committee. This body consists of a representative from the treasury who represents the government. In the previous period, the interest rates in England have been set at a rate of between 0.5% and 1%.
The impacts of the rise in interest rates from 0.5% to 1% will have both positive and negative impacts on the organization. To begin with the organization will benefit from the tax deductions made before the business income is taxed. Since tax is an expense allowable, the business tax liability will have to reduce (van Deventer and Kenji , 2003).
The second positive advantage is that an increase in interest rate will make the business carry out proper investment appraisal in order to ensure that the projects are viable. When proper feasibility study is conducted the losses that may arise due to complacency will reduce making the business increase its net income.
Finally, an increase in interest rate may make the organization reduce its level of leverage. Internal and owners funds which may be cheaper will be favored and thereby enable the business change its capital structure (Duffie and Kenneth, 2003). It may also help in correcting the high leverage that may increase the liquidity risk of the organization.
On the contrary, an increase in the rate by 5% may have adverse effects on the business. To begin with, this increase will lead to increased interest expense by £32500.as a result there will be a decline in the company’s income.
The second negative impact of this rise is a reduction in the company’s cash flow. Since this expenses are paid from the cash flows, this will reduce the amount of cash business realize. If not well monitored, it may make the business experience difficulties in discharging some of its obligation i.e. the payment of other creditors.
Finally a rise in the rate of interest will make the company has few cheaper sources of funds (Kellison, 1970). Lando (2004) adds that the organization may thus be forced to avoid undertaking some projects which may be income generating. In this way the growth prospects of the business will be hampered and this will affect the long term objectives of the business.
Conclusions and recommendation
Interest rates determine the operation viability of the business and therefore its impacts should be scanned, the interest rate determination should not be based solely on fixed rates but also consider the demand for money. It can therefore be concluded that the cost of capital must be looked into before determination of the optimal capital structure.
Duffie, D. and Kenneth J. S. (2003) Credit Risk: Pricing, Measurement, and Management. Princeton University Press.
Kellison, S. G. (1970). The Theory of Interest. Richard D. Irwin, Inc..Library of Congress Catalog.
Lando, D. (2004). Credit Risk Modeling: Theory and Applications. Princeton University Press.
O’Sullivan, A. and Steven M. S. (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 458.
van Deventer, D. R. and Kenji I. (2003) Credit Risk Models and the Basel Accords. John Wiley & Sons.