- July 29, 2022
- Posted by: Ramkumar
- Category: Posts
How High-Interest Rates Affect Entrepreneurs
The rise in inflation has triggered #centralbanks globally to increase interest rates. Although this monetary action prevents currency devaluation, it is detrimental to entrepreneurs who rely on external financing for business growth. Let me explain.
As interest rates increase, founders who want to raise capital must give a higher percentage of their pre-tax profits as interest expenses. In addition, if the borrower’s credit rating is less, which is evident for start-up burning cash, lenders charge higher interest rates to account for the default risk.
At higher interest rates, the interest expenses rise, resulting in a higher percentage of profits going to lenders, demotivating borrowers to work hard.
For instance, if a founder has
Cash on hand = A
Investment needed for the project = I
Then, the founder raises 𝐈-𝐀 𝐚𝐬 𝐚 𝐥𝐨𝐚𝐧 𝐟𝐫𝐨𝐦 𝐚 𝐥𝐞𝐧𝐝𝐞𝐫.
If cash flows from project = R and
Ph is probability R>0; PL is the probability R<0, and
R = RL+RB, where RL is the cash flow to the lender and RB for the borrower
At higher interest rates, even when R>0, most profits go as interest expenses to the lender, and the borrower gets fewer profits for his effort. Thus, the borrower has incentives to consume cash for his benefits. If B is the private benefit,
At PL->R<0, payoff = 0 for borrower and lender
the lender would receive 𝐏𝐡*𝐑𝐋=𝐈-𝐀 𝐚𝐧𝐝
If i is the interest rate for a loan,
Cash flow for Lender RL= (1+i)*(I-A)
Substituting I-A to Ph*RL gives
(𝟏+𝐢) = 𝟏/𝐏𝐡
If Ph=1, i=0 implies that the project invested is a risk-free project.
As Ph->0, i->infinity implies that the interest rates rise with low NPV projects.
At PL, where R<0, interest rates rise, borrowers get motivated to consume cash for their benefits resulting in higher default
Thus, as interest rates rise, higher NPA increases the chances of scams.
As long as we 𝐝𝐨𝐧𝐭 𝐫𝐞𝐬𝐭𝐫𝐮𝐜𝐭𝐮𝐫𝐞 𝐝𝐞𝐛𝐭 𝐟𝐢𝐧𝐚𝐧𝐜𝐢𝐧𝐠 𝐟𝐫𝐨𝐦 𝐜𝐨𝐧𝐭𝐫𝐚𝐜𝐭𝐮𝐚𝐥 𝐜𝐥𝐚𝐢𝐦𝐬 𝐭𝐨 𝐫𝐞𝐬𝐢𝐝𝐮𝐚𝐥 𝐜𝐥𝐚𝐢𝐦𝐬, 𝐡𝐢𝐠𝐡𝐞𝐫 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞𝐬 𝐚𝐫𝐞 𝐝𝐞𝐭𝐞𝐫𝐦𝐢𝐧𝐚𝐧𝐭𝐚𝐥 𝐭𝐨 𝐞𝐧𝐭𝐫𝐞𝐩𝐫𝐞𝐧𝐞𝐮𝐫𝐬𝐡𝐢𝐩, 𝐣𝐨𝐛 𝐜𝐫𝐞𝐚𝐭𝐢𝐨𝐧, 𝐚𝐧𝐝 𝐆𝐃𝐏 𝐠𝐫𝐨𝐰𝐭𝐡.
If we fail to do that, we need to control inflation to manage interest rates, or the real growth rate should exceed inflation so that high growth projects compensate for rising interest rates.
𝘿𝙞𝙨𝙘𝙡𝙖𝙞𝙢𝙚𝙧 – 𝙄 𝙙𝙚𝙫𝙚𝙡𝙤𝙥𝙚𝙙 𝙩𝙝𝙚 𝙖𝙗𝙤𝙫𝙚 𝙚𝙦𝙪𝙖𝙩𝙞𝙤𝙣 𝙗𝙮 𝙖𝙣𝙖𝙡𝙮𝙯𝙞𝙣𝙜 𝙗𝙖𝙣𝙠𝙞𝙣𝙜 𝙨𝙘𝙖𝙢𝙨 𝙞𝙣 𝙄𝙣𝙙𝙞𝙖, 𝙖𝙣𝙙 𝙩𝙝𝙞𝙨 𝙚𝙦𝙪𝙖𝙩𝙞𝙤𝙣 𝙣𝙚𝙚𝙙𝙨 𝙖𝙣 𝙪𝙥𝙙𝙖𝙩𝙚 𝙩𝙤 𝙨𝙖𝙩𝙞𝙨𝙛𝙮 𝙖𝙡𝙡 𝙘𝙤𝙣𝙙𝙞𝙩𝙞𝙤𝙣𝙨. 𝙃𝙤𝙬𝙚𝙫𝙚𝙧, 𝙩𝙝𝙚 𝙛𝙪𝙣𝙙𝙖𝙢𝙚𝙣𝙩𝙖𝙡 𝙧𝙖𝙩𝙞𝙤𝙣𝙖𝙡𝙚 𝙧𝙚𝙢𝙖𝙞𝙣𝙨 𝙩𝙝𝙚 𝙨𝙖𝙢𝙚.