Corporate Finance and Macroeconomics

“I’m going into Business Admin. Why do I have to take macroeconomics? I’ll never use this stuff!” A comment we hear all too often from our first year students that are forced by their cruel advisors to take our courses. We hope this June 5th article from Reuters and the following explanation illustrates the direct relationship between the two subjects. Click here for article.

A recent report from the Royal Bank of Canada suggests that senior executives from companies around the world are avoiding going to the markets to raise cash even though interest rates are still at extremely low levels. Corporate finance theory tells us that firms will undertake new capital projects when the net present value is positive. The discount rate used to perform the NPV calculation depends, in part, on the risk free interest rate. In Canada, one-year treasuries are yielding 1% in nominal terms. Why, then, aren’t firms taking advantage of the low interest rates and investing in new plants and equipment.

The answer may lay in the macroeconomic forecast for the next two years. With most industrialized countries in the world reducing government spending and raising taxes to deal with their rising debt levels, the growth in global aggregate demand is expected to slow. Slower economic growth means that there will be fewer capital investments that have lower NPVs today than they will in a year or two. It is therefore prudent for firms to put off investment spending for 1-2 years.

This reduction in investment spending, as one of the components of aggregate demand, further reduces the growth rate of GDP. Measures of business confidence show firms’ expectations of short term economic conditions. When confidence is low, so is investment. This idea reinforces the Keynesian argument for deficit spending – an argument we have discussed in a previous blog.
Firms are currently avoiding raising funds by issuing capital because it is currently too expensive. With market indexes some 20% below their recent highs, equity has become 25% more expensive. Watch for signs of recovery in China to stimulate export spending in the rest of the world. This will cause global GDP to rise and the subsequent increase in business confidence will lead to increased investment.

This may seem to be a circular argument: a decrease in investment reduces GDP which reduces confidence, which reduces investment. It is more like a self-fulfilling prophecy. Investment is, after all, the most volatile component of aggregate demand and the cause of most recessions and recoveries.

(“Investment” is used in the economic sense; the production of real capital.)