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Overview
Time Value of Money Effects of Compound Interest Concentration of Wealth Present Value
The initial amount lent, called the principal amount The time period of the loan The interest rate The time period to which the interest rate applies
Note that there are two separate and potentially different (in fact, usually different) time periods involved: (1) the time period of the loan, and (2) the time period to which the interest rate applies.
To examine that relationship, lets let the Capital owned by person k be C(k), the income from Capital be i*C(k) (so the interest rate, or return on capital, is i), the production generated by person k from Labor be L(k), and the total expenditures related to person k be E(k). It is relevant and even important to note that the total expenditures, E(k), related to a person consist of three components: (1) personal expenditures (for self and dependents), (2) production expenditures (represented in part by overhead, which includes management, space, etc., and in part by materials), and (3) societal expenditures (represented primarily by government and, thus, taxes). (The difference between the E(k) and the personal expenditures of person k, is what Karl Marx refers to as surplus value. That is, it is the excess of a persons production over what is directly received for it.) Normally, one would expect the total expenditures, over all persons, to be less than or at most equal to the total production over all persons (otherwise the accumulated social wealth of the past will be dissipated). If L(k) E(k) + i*C(k) > 0, there will be a net addition to societal capital (and, of course, if L(k) E(k) + i*C(k) < 0, a net reduction to societal capital) from person k. Lets suppose that person k is permitted to keep the increase (or lose the decrease) and add it to (or subtract it from) C(k).
Now, consider two persons, P1 and P2. Let C(k), k = 1, 2 be their respective ownership of the societal wealth. So their income from Capital will be i*C(k), respectively. Let their respective production from their Labor be the same, L, and let their respective consumption also be the same, E. Thus, in this context, they differ only in their relative wealth. Then, their respective net savings will be S(k) = i*C(k) + L E. The total societal net savings will be S(1) + S(2) = i*(C(1) + C(2)) + 2*(L E). The individual net savings result in a new distribution of capital wealth: C(k) = C(k) + S(k) = C(k) + i*C(k) + L E Let C(1) = C(2) + X, so that, if X > 0, P1 has more wealth than P2. Then, C(1) = C(2) + X + i*(C(2) + X) + L E = (1 + i)*(C(2) + X) + L E and C(2) = (1 + i)*C(2) + L E C(1)/C(2) = 1 + (1 + i)*X/C(2) = 1 + (1 + i)*X/((1 + i)*C(2) + L E) If L E < 0, then (1 + i)*C(2) > (1 + i)*C(2) + L E and therefore (1 + i)/((1 + i)*C(2) + L E) > 1/C(2) Therefore, C(1)/C(2) > 1 + X/C(2) = C(1)/C(2) Thus, if the expenditures related to a person are greater than the production related to that person, that persons relative share of the wealth will be reduced, even though his amount of wealth may increase.
At the next level, the degree of concentration reaches the point where those with the most wealth do not need to subsist on the results of their labors, but can do so solely on the income from their wealth. Lets suppose that subsistence requires an income of at least Z. In current economic terms, that might be the federal poverty level, which for a family of 4 is about $20,000. If the interest rate is, just for illustration, at 5%, a level of wealth of $400,000 would generate that level of income, without the need to work. Working would then, of course, provide the resources for life beyond the poverty level, or for increasing ones wealth, or for some mix of the two.
At the next level, the degree of concentration reaches the point where those with the most wealth do not need to subsist on the results of their labors, but can do so solely on the income from the income from their wealth. Continuing with the example of Z = $20,000 as the subsistence level, that means that the income from the wealth generates $400,000 per annum so, at 5%, the wealth must be $8,000,000. The important point here is that the growth in wealth no longer depends at all upon labor, but can be generated solely from the interest. Indeed, if the person could subsist on the $20,000 per annum, the capital wealth would increase by nearly 5% per annum and thus would double in 15 years! At this level or perhaps at the next one, the capital ceases to be money. It becomes power and control.
I want to examine one final level simply to show what happens. Let the wealth accumulated by a person be such that subsistence can be obtained from the income of the income on the income (three levels remove from the need for labor). Continuing with Z = $20,000 as the subsistence level, the wealth would need to generate $8,000,000 in income so, at 5%, that implies wealth of $160,000,000. Clearly, this is at the level where money represent power. And we have not gotten even close to Bill Gates!
Simply to illustrate some of the relationships among the things I have just discussed, lets look at the U.S. national economy. From the 1997 Input/Output Tables, we have the following data:
Total Intermediate Input Product from Capital, Labor (Value Added) Government taxation Additions to capital Net for Capital and Labor 8.8 = a*(L)b *(C)(1-b)
= $6.7 Trillion = $8.8 Trillion = $2.7 Trillion = $1.3 Trillion = $4.8 Trillion
Let C = K*L. Then 8.8 = a*L*K(1-b) Net for Capital and Labor = L + i*C = 4.8 If i = 5%, then L + .05*C = 4.8 If a* K(1-b) = 10, then L = .88 and C = 3.92
Present Value
The Role of Present Value of Money Calculating Present and Future Value of Money Using Net Present Value Analysis Selecting a Discount Rate Identifying Cash Flows to Consider Determining Cash Flow Timing Selecting the Best Alternative Identifying Issues and Concerns
If the future dollars are the same for each year, say Fy = F,
t 1 t (1 + r) t-1 1 let S = so (1 + r)*S = = y=1 (1 + r) y y=1 (1 + r) y y=0 (1 + r) y 1 1 1 (1 + r)t - 1 (1 + r)*S S = = 1 = (1 + r)0 (1 + r)t (1 + r)t (1 + r)t
Hence:
(1 + r)t - 1 P = F*S = F r*(1 + r)t
There are times when the present value analysis needs to consider a cash stream in perpetuityfor an infinite period of time. Consider the formula shown above (1 + r)t - 1 P = F*S = F r*(1 + r)t but let t be infinity. Note that the second term in the expression on the right becomes zero and the first term, 1/r. The result is that P = F/r
Step 1. Select the discount rate. The term of the lease analysis is three years, so we will use the nominal discount rate for three years, 5.4 percent. Steps 2 and 3. Identify and establish the timing of the costs/benefits to be considered in analysis. The expenditures and receipts associated with the two offers and their timing are delineated in the table below: (Parentheses indicate a cash outflow.)
y 0 1 2 3
Step 4. Calculate net present value. The table below summarizes for each alternative.
y 0 1 2
NET PRESENT VALUE OF OFFER A Cash Flow DF PV ($10,000) 1.000 ($10,000) ($10,000) 0.947 ($9,470) ($10,000) 0.897 ($8,968) Net Present Value ($28,438)
NET PRESENT VALUE OF OFFER B Cash Flow DF PV ($29,000) 1.000 ($29,000) $2,000 0.849 $1,698 Net Present Value ($27,302)
Step 5. Select the offer with the best net present value. In this example, it is Offer B, the offer with the smallest negative net present value.
Step 1. Select the discount rate. The term of the lease analysis is three years, so we will use the nominal discount rate for three years, 5.4 percent. Steps 2 and 3. Identify and establish the timing of the costs/benefits to be considered in analysis. The expenditures and receipts associated with the two offers and their timing are delineated in the table below: (Parentheses indicate a cash outflow.)
t 0 1 2 3
Step 4. Calculate net present value. The table below summarizes for each alternative.
t 1 2 3
Net present value of Offer A Cash DF PV Flow ($18,000) 0.9731 ($17,516) ($18,000) 0.9215 ($16,587) ($18,000) 0.8727 ($15,709) Net Present Value ($49,812)
Step 5. Select the offer with the best net present value. In this example, it is Offer A, the offer with the smallest negative net present value.
THE END