Time Value of Money Essay
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Interest rate pertains to the earning which is made over time (Valentino, 2002). Two important parties are engaged in this scenario – the borrower and the lender. The borrower incurs the losses while the investor has the interest, the profit, after the term is fulfilled. There are two main types of interest rates according to their nature: nominal interest rate and the real interest rate.
Nominal interest rates are fixed and normally contract bound for a given term. While real interest rate takes inflation into account, thus the interest rate is subject to change over time, depending on the economic conditions (Dr.
Johnson, 1994-2005). For example, a $10,000 loan with an interest rate of 20% payable for 2 years will have the same interest rate until the 2-year term ends under a nominal interest rate setting while the interest rate is likely to change after the 1st year under a real interest rate setting.
Interest rates can also be classified according to their earning power: simple interest and compound interest. In simple interest, only the principal amount gains interest. While in compound interest, the current amount (principal + the previous interest incurred) will gain the interest (Valentino, 2002). For example, if Mr. X borrowed $10,000 from a bank with a simple interest rate of 10% annually.
The interest will be equal to $10,000 X 0.10 X 2 which is equal to $2,000. Hence, the accumulated value will be equal to $10,000 plus $2,000 which is equal to $12,000 after the 2-year term. While under compound interest, after the first year, the interest would be $10,000 X 0.10 = $1,000 and the accumulated value will be $11,000. This will become the new principal. After the second year, the interest would be $11,000 X 0.10 = $ 1,100 and so the accumulated value would be $ 12,100 at the end of the 2-year term (TVM 1.2.2 Java Bean, 2007)
Discount rate is not much different from the interest rate. Actually, it is also governed by the same principle. The only difference between the two is that the interest is paid at the end of the term under an interest rate, but under a discount rate, the interest is paid immediately or at the beginning of the period (Dr. Johnson, 1994-2005).
Using the previous example, under a simple discount rate of 10% if Mr. X would have to borrowed the same amount then, the bank would not give him $10,000, but less the interest. Since the interest must be discounted at the beginning, then the bank will only lend him $8,000 but he has to pay $ 10,000 at the end of the 2-year term (TVM 1.2.2 Java Bean, 2007).
Clearly, the interest and discount rate are some of the most important economic indicators. Proper computation and data would give economists a measure of how much an interest rate would be. Therefore, to preserve the value of money through time, analysts should accurately measure the current economic trends and implement the most accurate rates as possible.
Valentino P. (2002). Interest Rates. Retrieved August 17, 2007, from Economics Web Institute. Website: http://www.economicswebinstitute.org/glossary/interest.htm.
Dr. Johnson, P.M. (1994-2005). A Glossary of Political Economy Terms: Discount rate. Retrieved August 17, 2007, from Auburn University. Website: http://www.auburn.edu/~johnspm/gloss/discount_rate.
TVM 1.2.2 Java Bean. Retrieved August 17, 2007 from: http://www.getobjects.com/Components/Finance/TVM/tvm.html.