By David Born and Christian Krys

Inflation has returned – and alongside, we are currently witnessing a reversal of monetary policy by central banks around the world. Macroeconomic consequences aside, rising central bank interest rates also impact companies' financing conditions. This raises the question to what extent such a change is affecting corporate investments. How will corporates respond to the new interest rate environment? And what are the most important internal and external factors influencing companies’ investment decisions?

What does investment theory tell us?

In investment theory, the level of the real interest rate (nominal interest rate - inflation rate) plays an important role in firms’ investment decisions, as this affects the financing costs of an investment and thus its profitability – or even its feasibility. Regarding debt-financed investments, the interest rate represents a direct cost factor of the investment project, while regarding equity financed investments, the level of interest rate represents a form of opportunity cost.

Macroeconomic theories as diverse as Keynesianism and the Neoclassical School both share the assumption that rising interest rate levels have a negative impact on investment.

Indeed, increases in key interest rates are already observable in the rising cost of financing for companies and households. The cost of borrowing for non-financial corporates in the euro area has more than doubled on average, now reaching 3,1%, up from 1.4% at the beginning of 2022. In the United States, cost of borrowing has more than doubled as well, reaching now more than 5.5% (see figure 1).

What does empirical reality say?

The rise in financing costs raises the question to what extent companies are still willing to make investments in the current high interest climate at all – especially given the fact that many sectors are in the midst of an economic transformation regarding increased digitalization as well as net-zero emission targets, making investment an urgent necessity.

To answer this question, one needs to evaluate the current financial situation of companies. For this purpose, we have examined the extent of interest expense as a proportion of EBIT in the past fiscal year and assessed the effect of a potential doubling of half of last year’s interest expense on EBIT using a broad sample of nearly 4,000 companies from countries in Europe and the US with sales of at least USD 10 million. The assumption of a doubling of half of the interest expense represents a necessary simplification, as companies’ financing structures and maturity dates differ. Nevertheless, for the multitude of companies considered, approximately half of the debt will have to be rolled over in the coming two years, so that the resulting increase in interest expense can be anticipated accordingly.

The results show that the assumed increase in interest expense will significantly decrease the companies’ net income. Whereas for the average company the share of interest expense as a proportion of EBIT was 22%, in the scenario of increased interest expense that share would increase by ten percentage points to 32%.

All sectors observed would see an increase in interest expense as a percentage of EBIT. Under these conditions, the basis for financing investments, either equity or debt-financed, will in any case be weakened. Nevertheless, while higher interest rates put a strain on companies’ margins, they do not render further investment unfeasible.

In figure 3, quarterly data from 1960 to 2022 has been examined for various industrial countries. Considering the correlation between 10-year government bond yields as a proxy for long term interest rates and growth rates in Gross Fixed Capital Formation, it quickly becomes apparent that no significant correlation is discernible.

Recent survey results support this finding. A survey among more than 300 CFOs of US based companies conducted by the Duke University in collaboration with the Federal Reserve Bank of Richmond in November and December 2022 found that nearly 60 percent of the companies surveyed will not pull back on spending plans due to rising interest rates.

As investment decisions are influenced by a variety of internal and external factors, rising interest rates therefore not necessarily lead to corporate investments flows drying up. Such factors vary from project to project and from decision maker to decision maker. External factors, for example, include business environment factors and government policy. Business environment factors such as developments in science and technology, culture, society and/or health related issues, such as the COVID-19 pandemic, but also economic expectations, demographical trends or competition are impacting corporate decision making. Furthermore, government policies such as fiscal or trade policies will affect companies returns and thus also influence their investment decision. Internal factors include behavioral factors, company performance and the level of risk of investment decisions.

Empirical data and survey results confirm the view that there is, at present, only a minor danger that investment demand will dry up, especially in light of the wide-ranging transformation that many economic sectors are currently undergoing.