Final answer:
The Federal Reserve's rate increase affects the Present Value of Free Cash Flow model's denominator by raising the discount rate. Secondary consequences affect both the numerator (free cash flows) and denominator (interest rates), which could result in lower equity valuations.
Step-by-step explanation:
When the Federal Reserve announces a 3/4 point increase in the Fed Funds rate, this affects the Present Value of Free Cash Flow model by impacting the denominator, which consists of the discount rate. The denominator will increase because the discount rate incorporates the risk-free rate, which is influenced by movements in Federal Reserve rates. Consequently, equity valuations are typically lowered because the cash flows are discounted at a higher rate, reducing present value.
A secondary consequence of the rate increase could affect both the numerator and the denominator. For the numerator, which represents future free cash flows, higher interest rates could lead to reduced business investment and consumer spending, potentially lowering corporate earnings and hence forecasting lower cash flows. For the denominator, any adjustments to the risk premium, which might increase due to higher perceived market risk or a slow down in economic activity, would lead to higher rates used in discounting, further decreasing equity valuations.
Other considerations include the central bank's goal of moderating asset bubbles and leverage cycles by adjusting monetary policy, which can have a broad impact on financial markets and influence interest rates across various financial instruments.