Interest Rates and Compounding
In most business cases, borrowing money is not necessarily a free enterprise. It costs companies money to obtain funds on credit to finance various aspects of their business. The fee that a borrower pays to a lender for use of its money is interest. The annual percentage rate (APR) makes assumptions based on simple interest, which is interest only earned on the principal investment.
Another method of accruing interest is through compounding. Compound interest is not only charged on the original investment, but also assessed on the interest charged or earned for each period. When comparing interest rates, it is best to use effective annual rates. This compares interest paid or received over a common period (1 year) and allows for possible compounding during the period (Brealey, Myers, & Marcus, 2007). The effective annual interest rate allows for figuring out what the monthly fee of borrowing money will cost a business.
The present value of money is also known as discounting. The discount rate is sometimes called the opportunity cost of money. Money can be invested to earn interest. Because money is of more value when it is cash in hand, the person holding the cash can invest the cash and in return earn interest. When payments are not received, cash flow is reduced and therefore, interest earned is reduced. The relationship between present value and time and interest rate is exponential. The greater the interest rate, the smaller the present value.
The future value of money is also known as compounding. Future value is calculated by understanding how much interest the money will earn, how long it will be earning the interest and if the money will be compounded annually or at another interval. The impact of future value on an investment most likely will be greater than the present value.
Many times firms need to decide on how to best utilize its cash on hand. Should they invest it in the stock market or purchase more equipment with the hopes that it will increase productivity and profitability? A tough decision in some cases, but businesses should determine which is the wiser choice based on their financial situation. The opportunity cost associated with these choices is whether or not the company could have earned more money by choosing to do something else with the funds. TVM help managers in figuring out which of the opportunities presented is the best option. The preferred alternative increases the companys monetary value today as opposed to a later point in time.
The Rule of 72³In finance, the rule of 72 is a method for estimating an investments doubling time or halving time. These rules apply to exponential growth and decay respectively, and are therefore used for compound interest as opposed to simple interest calculations (Wikipedia, 2008). For example, if one would like to know how long it would take to double a given amount of money at eight percent interest, divide 8 into 72 and get 9 years. When a company can quickly calculate the return on investment, they will be able to make quicker and more informed decisions in regard to the investment or budget decision.
The Time Value of Money is an important concept in financial management. Money left on its own is devalued by inflation. Investors, therefore, need to find a way to make their money grow faster than the rate of inflation. One method is through interest paying investments. Compounding interest accelerates return on investments, provided an investor can obtain a fixed rate of interest. Whichever method an investor chooses, understanding the time value of money is crucial to successful investment outcomes.
Brealey, R. A., Myers, S. C., & Marcus, A. J. , (2007). Fundamentalsof Corporate Finance. New York, NY: McGraw-Hill/Irwin.
Wikipedia, (2008). Rule of 72. Retrieved March 24, 2008, from theWikipedia Web site: http://en.wikipedia.org/wiki/Rule_