IBD Interview Question: How would rising interest rate affect a company's decision on how to finance an acquisition?
The exact interview question is: What are the driving forceｓ of interest rate, why is interest rate so low and how would rising interest rate affect a company's decision on how to finance an acquisition and in what way it will change the consideration (% cash, % Debt, % Equity)
Driving force of interest rates stems from the availability of the money supply. Stems monetary policy decisions by the Federal Reserve, or other central banks around the world. If loose policy is the agenda, they will decrease rates, by flooding the economy with money and increasing supply, and if they want to increase rates, they drain the economy of money in order to reduce the supply and push rates up.
Interest rates are low because we have had very loose monetary policy in the years following the 2008 crisis, and this has caused interest rates globally to collapse to almost 0, and in some cases go negative in hopes to stimulate borrowing/lending and spending in the economy.
M&A activity is generally negatively correlated to the direction of interest rates. As Rates go down, the cost of both debt and equity go down, and when rates go up the reverse happens. This makes the overall cost to fund acquisitions go down as a whole. Also, discount rates across the board will fall or rise pushing valuation up and down.
As far as cash is concerned, in a falling rate environment you will use less cash because you can get cheap funding and in a rising rate environment you may want to use more so as not to incur the expensive financing. However, the cash component of the deal could have to do with a number of factors such as the strength of the current market (Strong Market may use more equity to finance vs. weak market targets may demand more cash)
There are many forces that drive interest rates, like the overall state of the government and such. One of the main ones would be the supply and demand available for credit and what the central banks wish to do with this market for credit. Right now, interest rates have been very low, mainly because the government/central banks needed to help get the world economy (USA) back on it's feet after having so much credit in the system that ultimately caused 2008. The Fed thought the best way to appease the markets and increase consumer confidence would be to lower the rates as this would help to stimulate borrowing and hence possible economic activity from both businesses and consumers. Problem is, this hasn't worked out to be the case. Inflation rates are still low and below the target, people have shoved this cheap money into a stock market instead of real investments. Now, if we look at your main question of how a rising interest rate will affect a company's decision on how to finance an acquisition, think of it like this:
Cash: Rising interest rates make the opportunity cost of cash a bit higher because bank accounts can yield more returns. Debt: Debt issued in a higher rate environment will be a bit more expensive than before. Stock: Knowing that investors love stocks when rates are low, when rates start to increase, you will see a shift of capital out of stocks and into bonds. Companies' current funding costs may also go higher, but the overall trend of a P/E ratio should move lower. This would mean that the cost of stock in a deal will be higher.
As you see, all funding costs for a transaction have risen. Now, it is up to the company on what exact transaction structure to use, but you know for a fact it will be more expensive overall now.
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