Understanding Interest Rates, Inflation, and Cash Flow
Theme I: Interest Rates and Inflation
Interest: The price to pay for foreign capital available for a certain period.
Interest rate: The percentage of invested capital that is paid for using it in a given unit of time (usually one year).
Types of Interest Rates
- Lending Rate: The percentage that banking institutions, according to market conditions and provisions of the central bank, charge for different types of credit services to users. These are active because they are resources for the bank.
- Deposit rate: The percentage a bank pays to those who deposit money using any instrument designed for that purpose.
Real interest rate: The percentage resulting from deducting the prevailing inflation rate from the interest rate. If the interest rate effect is greater than the rate of inflation, a positive real interest rate is obtained; that is, the amount saved will buy more at the end of the year than at the beginning. If the effective interest rate is lower than the rate of inflation, a negative real interest rate is obtained; that is, the amount saved will buy less at the end of the year than at the beginning.
Prime Rate: A percentage of general internal loans charged for specific activities to be promoted by either the government or a financial institution.
External Rate: The price paid for the use of foreign capital. It is expressed as a percentage per annum and is set by the countries or institutions that provide financial and monetary resources.
Fixed interest rate: The interest rate that applies during the repayment period of a loan, whose value is fixed at the time of the conclusion of the credit.
Floating rate: The rate paid during the life of the loan, which varies based on a benchmark interest rate.
Interest rates to counter: The interest rate that is applied to the balance.
Cash Flow
Cash flow: The calculation of the amount of income and expenditure that will occur in a company during a specific period.
Cash Flows Can Be Classified Into:
- Operating cash flows: Cash received or expended as a result of the basic economic activities of the company.
- Investment cash flows: Cash received or expended by considering the capital investment expenditure that will benefit the business in the future.
- Cash flows from financing: Cash received or expended as a result of financial activities, such as receiving or paying loans, issuing or repurchasing shares, and/or paying dividends.
Preparing a Cash Flow
- Inflows: This is the money that enters the company for its production activities or services, or proceeds from the sale of assets (disinvestment), grants, etc.
- Outflows: This is all the money that leaves the company and is necessary to carry out its production activities. It includes variable and fixed costs.
Calculation of personal cash flow: Cash flow = Net income + Depreciation + Provisions
Present Value Factor for Single Payment Compound
The term “present value factor for single payment compound” is a factor multiplied by a single payment for the amount capitalized at a specified future date. The resulting factor (1 + i)n, is known as the single payment compound factor, which can be used to find the compound amount, F, from a principal, P, through the following relationship: F = P (1 + i)n, where n is limited in years, i is the percent interest rate, and P is the amount invested. F, the future value, is the amount of money available at the end of the transaction.
Pay Factor for a Series of Equal Payments Compounds
The resulting factor [(1 + i)n – 1] / i is known as the compound amount factor series of equal payments and is designated as FAF. Where: F = A x FAF
Sinking Fund Factor Series with Equal Pay
The resulting factor i / [(1 + i)n -1] is known as the sinking fund factor with a series of equal payments. Where: A = F x FFA
Nominal Rate
The interest is compounded more than once per year. This reference rate is set by the Central Bank of a country to regulate lending (loans and credits) and liabilities (deposits and savings) of the financial system. It is a simple interest rate. The nominal rate equation is: j = interest rate per period x number of periods
Effective Rate
These are the rates that effectively capitalize the capital. The capitalization of interest a certain number of times per year results in an effective rate greater than the nominal rate. This rate represents the overall interest payments, taxes, fees, and any other charges involved in financial transactions. The effective rate is an exponential function of the periodic rate. The nominal interest rate can be calculated for any period longer than originally intended. For example, an interest rate of 2.5% per month can also be expressed as a 7.5% nominal per quarter (2.5% monthly for 3 months), 15% six-month period, 30% per annum, or 60% for 2 years. The nominal interest rate ignores the value of money over time and the frequency with which interest is capitalized. The effective rate is the opposite. Similar to nominal rates, effective rates can be calculated for any period longer than the time originally set.
Inflation
Inflation: The economic imbalance characterized by an increased, continuous, and widespread growth of prices of goods, services, and factors of production over time. It comes from the rise of paper money, deterioration, and mismanagement of a country’s economy, bringing consequences such as no adjustment in work contracts, loans, decreased purchasing power of money, and others.
Causes of Inflation
- War Inflation: We can speak of a country that may be well off and suddenly have conflicts or wars. When it becomes embroiled in a conflict, it has to divert its production to armaments, missiles, etc. Resources are allocated to wages, education, and production. Therefore, the government cannot raise taxes because everything is meant to be.
- Excess demand: This can be produced by the internal use of the reserve currency of the country (the amount of money saved in banks, either state or private). This can be for consumer spending, increased investment spending, or by raising the costs of production, such as a wage increase by official decree to try to calm the people, increasing production.
Impact of Inflation
Positives:
- For debtors, due to the devaluation of borrowed money, the currency’s purchasing power is not the same after some time.
- For vendors, as inflation drives up prices, inventories are revalued; that is, there is a positive change for them because inflation raises prices and adds value to the goods.
Negatives:
- For creditors who lent money worth a certain amount, but when the money is returned, it is not worth the same.
- For the productive mechanisms of foreign trade, it can curb Venezuela’s exports to foreign countries and encourage imports.
Types of Inflation
- Moderate inflation: Characterized by a slow rise in prices. Annual inflation rates are single digits. When prices are relatively stable, the public relies on money. In this way, it keeps cash within a certain time (month, year), having almost the same value as today.
- Rampant inflation: Inflation that has two or three digits, ranging between 20, 100, or 200% per year. When runaway inflation takes root, serious economic distortions occur. Generally, most contracts are linked to a price index or a foreign currency (dollar). Therefore, money loses its value very quickly, and interest rates may be 50 or 100% per year.
- Hyperinflation: This occurs when prices rise at rates exceeding 100% annually. When this happens, people try to dispose of liquid money before prices grow more and make the money lose even more value.
Effects of Inflation
- Effects on income distribution: These are the most frequently visible and prominent. Inflation hurts those individuals on fixed incomes in nominal terms and, in general, those whose income rises less than inflation.
- Effects on the economy: Inflation will also have distorting effects on economic activity, and the inflation process involves an alteration of the structure of absolute prices, increasing them equally.