Section A

Quantum AI is a highly geared technology startup. The central bank of the country where Quantum AI operates has recently announced a policy of quantitative tightening and significant increases in the base interest rate to combat inflation.

What is the most likely immediate impact of this macroeconomic policy on Quantum AI?

A highly geared company has a large proportion of debt. When central banks raise interest rates (quantitative tightening), the cost of servicing variable-rate debt increases, which reduces profit before tax and worsens the interest cover ratio. Furthermore, higher interest rates increase the risk-free rate, which increases the cost of equity (via CAPM) and lowers the present value of future cash flows, thus decreasing equity valuation.