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A note on ‘Interest rates’ in an economy - Bala

In any economy, the rate of interest given to a depositor in a bank depends upon the rate
of inflation in that economy. The depositor of a bank would like to receive a return,
which is higher than the rate of inflation. Similarly, it stands to reason that the rate of
interest charged on a loan by a bank would be higher than the rate of interest on the
deposits given by that bank, as the bank would incur administrative expenses and would
claim a percentage of profit also. Based on the above, we can very well imagine that in
case a project is financed in part by loan from a bank, the rate of return that the owner of
the project expects from it would be higher than the rate of interest on loans.

The above can be tabulated as under:


Tier No. I Rate of inflation, say 8% p.a.;
Tier No. II Rate of interest on deposits = Rate of inflation + 1 or 2% as compensation
for a depositor = 10% p.a.;
Tier No. III Rate of interest on loans = Rate of interest on deposits + 2 to 4% addition
towards administrative expenses + margin of profit for the bank say 1 to 2% = 13% to
16% p.a. and
Tier No. IV Rate of return expected from a project = Rate of interest on loans + some %
addition. The exact % addition entirely depends upon the expectation of the owner of the
project, which to some extent depends upon the risk associated with the project, i.e., the
higher the risk, the higher the % addition and vice-versa.

Application of time value of money in business

The "Cash flows" that accrue at a future date are not equal to the present profit, due to
inflation and hence this factor should be considered while comparing the present working
with future working.
When two or more alternative capital investment proposals are under consideration, the
future earnings or returns are converted to the present value and whichever project gives
a higher present value, that project is selected.
If we know the requirement of funds at a future date for a specific purpose, like going
abroad or purchase of a flat, we can determine what would be the amount that should be
set aside at present, so that at the expected rate of interest, the present value would
increase to the required future value.
It is the basis on which the leasing and hire purchase companies do business and give
quotations for their lease and hire purchase proposals.