The Fisher Effect

The Fisher Effect

To determine true return on a company's investment, the financial manager (FM) must be able to determine the real interest the company's investments are achieving, regardless of inflation. Irving Fisher theorized in his work The Theory of Interest: As Determined by Impatience to Spend Income and Opportunity to Invest it? that real interest is the price at which the supply of capital is equal to the demand for capital. The supply is dependent on peoples willingness to save and demand is dependent on peoples willingness to invest in viable opportunities (cited in Brealey, 2005, p. 626). This can be further approximated by the equation:

n = r + i

where n is the nominal interest rate, r is the real interest rate, and i is the rate of inflation (Chrisholm, 2003, p. 45). The demand for real interest remains stable regardless of inflation. This means that in times of higher inflation investors demand a higher nominal interest rate. In fact, for a 1% increase in inflation, investors will demand a 1% higher nominal interest rate. This is true irrespective of monetary policies such as balanced budgets and declining private borrowing (Bartlett, 2004, p.19). In times of higher inflation the investor demands a higher nominal interest rate to cover the loss of value due to inflation.

Understanding of the Fisher Effect can be essential to multinational companies, which operate in countries with differing inflation rates. FM's must forecast several countries exchange rates and inflation rates to accurately budget future growth. The Fisher Effect enables a company to evaluate two opportunities in countries with differing inflation rates and offering different nominal interest rates. For example, if country A is offering a 20% nominal return with 7% inflation and country B is offering 17% nominal return with a 6% inflation, application of the Fisher equation concludes that country A has a higher real return at 13% (Mannino, 1992, p. 39).

Long Term and Short Term Strategies

FM's must achieve a balance between the long and short-term needs of the company to sustain growth for the stockholders. "Short term finance is an analysis of decisions that affect current assets and current liabilities and

will frequently have an impact on the firm within a year" (Ross, 2005, p. 730). The goal of short-term financing or working capital management is to enable to company to continue operating and have sufficient funds to repay upcoming short-term debts and operational expenses (Maneval). Management of working capital requires the management of current assets and current liabilities. Current assets consist of cash, inventory and accounts receivable. The FM must choose how much cash to have available. Cash is liquid, but the trade-off is lower returns. High inventories provide fast service for the customer but higher costs to hold said inventory. Lower inventory levels have lower holding cost but increase the chance of stock outs and rush orders (Short term financial management). Using historical data, financial analysis and modeling, the FM must reach an optimum inventory level. Accounts receivable is credit offered to customers, trade credit. Sales on credit increase future sales but increase the cost of carrying the credit and chance for customers defaulting on the payment. The FM must determine how much credit, how long and what terms he or she is willing to offer to each customer, and does what is the risk of each customer defaulting (Short term financial management). Current liabilities consist of accounts payable, and short-term loans. The FM tries to get the best credit terms from his suppliers as possible to delay the