Both inflation and interest rates, in their ability to change the value of money over time, play a very important role in how corporations manage their liquid assets and their investments. Therefore, to have even a basic understanding of corporate finance, you must understand what the time value of money is and how it influences corporations.
You can measure the value of money in two ways:
In real terms: Real value is measured by the ability of money to be exchanged for other things. In other words, real value refers to the purchasing power of money, which includes nominal value plus inflation.
In nominal terms: Nominal value is very easy to measure because it’s simply a measure of the number of units of currency you have — that is, the volume of money. For instance, $10 will always have a nominal value of $10. A $1 coin, even if it’s made of pure diamond and is sought after by collectors for billions of dollars, still has a nominal value of just $1.
Only the real value of money, not the nominal value, is influenced by time. So $10 will still be $10 next year, but it’ll purchase less than it does this year. This distinction is very important because the goal of corporations is to ensure that their nominal value increases faster than the real value of each unit of currency decreases. In other words, they want to make more money faster than the money they have loses value.
Inflation
Inflation is when a currency’s ability to purchase goods (that is, its purchasing power) is diminished — that is to say, when its purchasing power decreases, causing people to spend more units of currency to acquire an equal quantity of goods. The three forms of inflation are
Cost push
Demand pull
Monetary inflation
You don’t need to worry about what causes inflation; instead, focus on the impact that inflation has on finances after it has already occurred. Really, inflation is quite simple: You know how things are more expensive than they used to be? Remember how the price of (insert the name of a consumer good here) used to be lower than it is now? That’s inflation.
Say that inflation is 1 percent per year on average. That means that every single year, you need 1 percent more money to purchase goods than you did the year before. In most cases, people also make 1 percent more money in wages than they did the year before, so generally speaking, people are earning and spending more money to maintain an equivalent quality of life.
Here’s another example: If inflation is 1 percent per year and you own $100, over the course of 10 years, that $100 will lose 10 percent of its value as measured by its ability to purchase goods.
Inflation can also work in reverse. Deflation occurs when money increases in value, meaning it’s able to purchase more goods for an equivalent price. Because of how economists around the world currently manage their respective national economies, deflation happens only during very bad recessions.
Interest rates
Interest rates are the other primary influence on the value of money over time. The interest rate is the rate of return you make on an interest-bearing asset or the rate you pay when you borrow money.
So if you have a bank account that generates 1 percent interest per year, then you’ll have 1 percent more money in that account next year than you have this year, assuming that you don’t touch the bank account during that year.
If interest rates are increasing the amount of money you have at exactly the same rate that inflation is decreasing the value of each dollar, then you can continually purchase the same amount of goods using the money in that bank account.
The way in which interest rates decrease the value of assets is a bit more abstract than inflation and has to do with the opportunity cost of holding an asset. Opportunity cost measures the loss of forgoing the next best option.
For example, the opportunity cost of making an investment that earns 2 percent interest may be the 1 percent returns of the next best investment. Opportunity cost becomes a problem when the next best investment is actually better than the one you chose.
For instance, if you buy a certificate of deposit (CD) that makes 2 percent per year and then the very next day the interest rate on CDs increases to 3 percent, then you’re generating less nominal value on your investment than the market is currently offering. In other words, you’re losing 1 percent per year by having the wrong CD because you’re earning less interest than what’s being offered.
