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IAI Actuarial Core Principles · Business Economics · Impact of the macroeconomic environment on business

The Reserve Bank of India raises its policy repo rate to curb inflation. Other things equal, which effect on an Indian manufacturing firm that finances expansion mainly through floating-rate bank loans is most likely?

A higher repo rate raises borrowing costs on floating-rate loans and the firm's cost of capital, so marginal projects no longer meet the required return and are deferred. It does not lower costs or improve appraisals.

  1. AIts interest cost rises and some investment projects fall below the required return and are deferredCorrect
  2. BIts interest cost falls because borrowing becomes more attractive for banks
  3. CIts project appraisals improve because the discount rate falls
  4. DIts export competitiveness rises immediately because the rupee must depreciate
  5. Its debt service burden is unchanged because the loans were taken earlier

Explanation

A higher policy rate feeds through to floating-rate loan costs, raising the firm's interest bill and its cost of capital. Projects whose returns were marginal then fail the hurdle rate and are postponed. A higher rate tends to attract capital inflows and appreciate, not depreciate, the currency.

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