Inflation and Interest rate

April 19, 2013
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A challenging economy throws a lot of odd problems to a business. Especially in an economy in which inflation and interest rate are volatile, business managers and investors are a confused lot. I will try to shed some light on this confusion and a way to solve it. 

We will first understand a bit about inflation and interest rate. Both are closely linked and are key drivers of an economy.  Then, we will see how inflation and interest rate affect business. At the end of this article, there are few questions for you to answer.  

Money supply and inflation

Inflation increases with the increase in supply of money in the economy. Let’s take an example how this works. Imagine you and I are in a market, we want to buy apples and we both have Rs. 50 with us. We will bid till we reach Rs. 50 to get those apples. Now the government comes in and doubles our paycheck. Now we will bid till we reach Rs. 100 to buy the same thing. We are paying more paper money to buy the same product and essentially the value of money has reduced. This is inflation. Now, you have a brief idea about inflation. You can read an earlier article – Value of Money to understand more about inflation.  

Interest rates are increased to control the inflation

Interest rate creates a reverse effect of inflation. As interest rate increase, people take lesser loans as they have to pay higher interest on loans. Further, people tend to make more deposits to earn interest on the deposits. Hence, people have less money to spend it.  Since less money is circulating in the economy, the demand for product decreases as a consumer spends less. You know that price of a product decreases with its demand. This means less paper money is required to pay for the products. Thus interest rate has essentially reduced the supply of money in the market. This is how interest rate is used to control inflation. You can read an earlier article – Interest rate: The price of money to understand more about interest rate.

How business is affected in high inflation and interest rate environment?

A business need to produce higher returns in high inflation period. Inflation reduces the value of money. This depends on the inflation in the economy. Higher the inflation less is the worth of money in your hand. Let’s say that the return on capital invested through equity in a business is 10%. You will get Rs. 10 on every Rs. 100 invested in shares of a business. Now, inflation is at 12%. Due to inflation, your return is reduced by 12% which means your actual return is 10% – 12% = -2%. In an inflationary period, the return on capital invested in business is reduced from 10% to -2%. This means that there is a pressure on management to produce higher returns on invested capital.  We will discuss this in next article how management can increase the return on invested capital along with answers to question given below.

Now, what happens when interest rate is increased to control the inflation? As interest rate increases, the business has to pay more interest to debt investors. This isn’t good either. Yes, there is a benefit of interest expense in the form of tax saving. But, the tax advantage is limited to the point where amount of taxes is higher than the interest expense. Thus, a business will look for cheaper source of capital in high interest rate environment.

Business case

Let’s take an example of a consumer products company such as Britannia. The company has slew of products in various categories including biscuits, drinks etc. Let us consider only their biscuit brand called Tiger for our discussion. As we know that inflation increases the price of products but it also increases the cost of raw material. Let us assume that the interest rate is high at this time in the economy. Here are few questions for you to ponder and answer.

Q. Does this reduce the margin of products? Margin is the difference between the price of product and the cost of producing the product. 

Q. What will a consumer product based company do to maintain its margin in high inflation and interest rate economy? 

Q. Is it a good time to buy the shares of such a company? What are the factors will you consider in selecting the company for your   investment? 

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Devendra Mangani

Devendra Mangani

Devendra is working in curriculum development and assisting finance faculty at Sunstone. He has worked with RBC capital markets, an investment bank in Canada and global manufacturing organization in various roles.
He is a graduate from IIT Bombay and holds an MBA from Queen’s School of Business, Canada.

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  1. Gunjan Gupta says:

    Q. Does this reduce the margin of products? Margin is the difference between the price of product and the cost of producing the product. 

    This would depend on the company's ability to increase the price of its product. Tiger is a brand which is popular among the masses and so it could be very price sensitive making it difficult to pass on the rice in price of raw materials to the consumer. If the company is able to pass on the rise in prices then the margin should remain same or else it should reduce. 

     

    Q. What will a consumer product based company do to maintain its margin in high inflation and interest rate economy? 

    It could pass on the price rise but that could be difficult for price sensitive products. It could also resort to reducing the weight of the product while keeping the price same. 

     

     

    1. You are right that margins will depends on the ability of the company to increase the price of product. The price of the product is not increased immediately as there is a fear of losing market share to competitors. Over a period of time, a brand like Tiger can increase the price of product. There is always a lag between the increase in price of product and cost of raw materials. During this period, consumer product company will have lower margins.    

      To maintain the margins, a company can also reduce operational expenditure while increasing the sales volume. They can also look for options to reduce taxes.    

  2. Q. Does this reduce the margin of products? Margin is the difference between the price of product and the cost of producing the product. 

    Yes this will reduce the margin of product as, chances of increase in ingredients cost are high, the cost producing the product will increase.

    Q. What will a consumer product based company do to maintain its margin in high inflation and interest rate economy? 

    1.       Increase price of product, however this might impact product sales.

    2.       Reduce the quantity/packet i.e. decrease number of biscuit in a single pack and let the price remain unchanged.

    3.       Reduce waste, increase operational efficiency, negotiate price with ingredient suppliers

    Q. Is it a good time to buy the shares of such a company? What are the factors will you consider in selecting the company for your   investment? 

    Not a good time to buy shares of such companies.

  3. Q. Does this reduce the margin of products? Margin is the difference between the price of product and the cost of producing the product. 

    Yes this will reduce the margin of product as, chances of increase in ingredients cost are high, the cost producing the product will increase.

    Q. What will a consumer product based company do to maintain its margin in high inflation and interest rate economy? 

    1.       Increase price of product, however this might impact product sales.

    2.       Reduce the quantity/packet i.e. decrease number of biscuit in a single pack and let the price remain unchanged.

    3.       Reduce waste, increase operational efficiency, negotiate price with ingredient suppliers

    Q. Is it a good time to buy the shares of such a company? What are the factors will you consider in selecting the company for your   investment? 

    Not a good time to buy shares of such companies.

    1. You are right that likelihood of lower margin is high. This will change as the consumer product company with strong brand presence can pass on the rise in cost of raw materials to the consumers. 

      To maintain its margins, a company can also increase volumes while reducing the operational expenditure. They can increase volumes by increasing the pack size and the distribution. The operational efficiency can be achieved by reducing the working capital. The negotiation of price with ingredient suppliers is also one of the steps in decreasing working capital requirements.    

      If the brand of the product is stronger than Tiger, then would you buy the share of the company. 

       

      1. Siddharth Jain says:

        Interesting that you said – increase he pack size. If one goes for increasing package size, it adds to additional cost of packaging because new packets would have to be created. Plus, that would typically mean some additonal advertising cost. Would one not try to avoid these costs at this point?

        1. If you increase the pack size, then customer is going to buy more at one transaction. This increases the sales volume. The packaging cost is less because you are reducing the amount of wrapper required to pack. The company is packaging two packets in one wrapper. The advertising cost will be same because the company will advertise bigger pack size instead of single pack.   

  4. Siddharth Jain says:

    Q. Does this reduce the margin of products? Margin is the difference between the price of product and the cost of producing the product. 

    A. COGS have increased so margin has definely reduced. 

    Q. What will a consumer product based company do to maintain its margin in high inflation and interest rate economy? 

    A. In order to have higher margin, one should be able to sell more number of biscuits at current price and margin or one should increase the price. Since, increasing sales incurs additional cost, in a high inflationary env, increasing price should not cause much issue or as folks have mentioned, one can reduce the quantity at same price levels.

    Q. Is it a good time to buy the shares of such a company? What are the factors will you consider in selecting the company for your   investment?

    A. The company is under pressure to maintain margins. At the same time, other overheads would also have increased due to high inflation. Hence, EBIT is expected to go down even if one is able to maintain the margins after some steps. With higher interest rates, the net income is also under pressure. So, it does not look like a time to buy stock

  5. No doubt the margins will reduce in short term but there is good chance that the company will be able to increase the price of product in the long term. The margins will expand in long term as the raw material price will come down. 

    For higher margins, a company can do both. It can increase the price of product as well as increase the volumes. This way they need to make only a small increase in the price of the product. Some of the companies with better cost management can improve the operational efficiency and reduce working capital requirements. A combination of these steps can help a company survive the high inflation and high interest environment.

    Typically investors look at margins to make investment decisions. From the lens of margins, this may not be a good time to buy the shares of the company but we might miss the forest for the trees. Here is another way to think about it. 

    High inflation and interest rate are external to the business. The biscuit brand of Tiger is well established in the market. Even in high inflation and high interest rate, the odds are in favor of its business. It is less likely that any competitor can replace it. Do you think this brand will outperform other brands in long term?    

    1. Siddharth Jain says:

      Point taken. AND is better than either/or :) . The thought did come to my mind that may be, in long term, this might prove a good time to buy stock but then I thought that best time to buy might be when the external factors change for positive. keeping external factor constant at this point based on problem, thought it wise to not invest. But then, no one can time market. Tiger should outperform as its a decently popular biscuit from what I understand

      1. You got it right. Now think about other consumer brands and see what will be your criteria to select such brands/companies for investment.