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Interest Rates as Required Rates of Return, Discount Rates, and Opportunity Costs

Interest Rates as Required Rates of Return, Discount Rates, and Opportunity Costs

Time value of money is a concept that states that cash received today is more valuable than cash received in the future. If a person agrees to receive payment in the future, he foregoes the option of earning interest had he invested that amount of money today. On the contrary, cash received today is more valuable due to inflation. It is imeprative to remember that inflation tends to reduce the purchasing power of money over time.

Assume that someone has $100 now. If he invests the money in a bank account, it will earn him an interest income. Note, however, that the interest income will depend on the rate of return offered by government bonds (risk-free assets), inflation, liquidity risk, default risk, time to maturity, and other factors.

Application of Time Value of Money

The time value of money concept has a wide range of applications in finance, including bonds valuation, shares valuation, loan facilities pricing, and capital budgeting, among others.

Key Components of Time Value of Money

  • Discount rate or interest rate: The rate of discounting or compounding that you apply to an amount of money to calculate its present or future value.
  • Time periods: The whole number of time periods over which the present or future value of a sum is being calculated. These time periods can be annually, semi-annually, quarterly, monthly, weekly, etc.
  • Present value (PV): The amount of money you have today (or at time T = 0) is referred to as the present value.
  • Future value (FV): The accumulated amount of money you get after investing the original sum at a certain interest rate and for a given time period, say, two years.

There are three ways to interpret interest rates:

  1. Required rate of return: The minimum return that an investor expects to earn to postpone their current consumption.
  2. Discount rate: The rate used to discount future cash flows in order to determine the present value.
  3. Opportunity cost: The interest foregone when investors spend money on current consumption rather than saving or investing their money.

Which of the following is most likely an interpretation of interest rate as benefit foregone when investors spend money on current consumption instead of saving or investing?

  1. Discount rate.
  2. Opportunity cost. 
  3. Required rate of return.

Solution

The correct answer is B.

Opportunity cost is a key factor in interpreting interest rates. It refers to the interest foregone when investors opt for an alternate option, such as spending on current consumption instead of saving or investing.

A is incorrect. The discount rate refers to the interest rate used to discount future cash flows to reach the present value.

C is incorrect. Required rate of return is the minimum rate of return an investor would wish to earn to postpone current consumption.

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