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.
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?