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UNITE: VOL.2 (NO.1) / June 2015 / ISSN: 2335-0628
University journal of
Information Technology and Economics
Available online: http://www.unite.edu.rs/
System for submission: http://www.unite.edu.rs/ojs
AN ANALYSIS OF TIME PREFERENCE THEORY OF INTEREST
AND ITS IMPACT ON THE BUSINESS ENVIRONMENT
Suad Bećirović
Department of Economics, University of Novi Pazar, Dimitrija Tucovića bb,n36300 Novi Pazar, Serbia,
s.becirovic@uninp.edu.rs
Article Info
Article history:
Received 17 Dec.2014
Received in revised form 15 Jun 2015
Keywords:
Interest Theories, Interest, Problems
of Interest, Monetary Theory,
Finance,
Economic Theory, Net present Value,
Time Preference, Use of Resources
Abstract
Interest has become a common phenomenon in economics. It has even
become one of the major indicators in economics. Time preference
theories of interest claim that without interest, as a corrective
mechanism, individuals would not have an incentive to save and the no
efficient mobilisation of funds would be possible. Time preference
interest theories have made their way to practice via the net present
value method, which is the major method for investment appraisals.
In this working paper the views of time preference theories of interest
are challenged and real reasons for the existence of interest are
presented. The other part of the paper covers a critical analysis of the
net present value method, which implements time preference theories
into practice. Here, especially the effects on investment choice based on
this method are critically analysed.
JEL Codes: B10, B26, N10
INTRODUCTION
Interest, or the interest rate, is seen as an indispensable
instrument in today's modern economic thinking. News about
the movement of interest rates is very important, because this
information will influence decisions with regard to saving,
consumption and investment. The interest rate is used as a
mechanism to attract savings, in order to have an efficient flow
of funds from savers to demanders for money. Without interest,
according to modern economists, savers will not have a
motivation to lend their savings and thus savings will be
consumed or hoarded, which will decrease investments and
consumption dramatically.
This general acceptance of interest in modern economic
theory has induced the authors to critically analyse the impact
of interest in today's business environment. The necessity of
interest was explained by interest theories, which try to explain
the necessity of interest from different perspectives. Because
there are many different interest theories, we will concentrate
on classic and neo-classic interest theories, which
emphasize time preference as a major reason for the existence
of interest. So, the main goal of this research are to analyse the
time preference interest theories, whether they are able to
explain the existence and for interest, whether their
assumptions are up-to-date for today's business environment
and how the influence behaviour of economic subjects, leading
to certain consequences.
In order to achieve this goal, we specify the following
hypothesis: Interest, or interest rate, has become a normative
statement in modern economics during the last two hundred
years, especially in financial thinking. Based on economic
theory, certain methods and tools have been developed, so
economic subjects can make rational decisions. But, the
authors claim that such thinking rather causes problems in
economic practice. Therefore, the authors claim that problems
in the financial system has to be solved in other ways, in order
to develop an efficient financial system.
The research will be conducted by analysing major time
preference interest theories of leading classical economic
Suad Bećirović / University journal of Information Technology and Economics / Vol.2 (No.1) / June 2015 / pp. 5-13
thinkers and by comparing their presumptions with positive
(realistic) economic behaviour. In the second part of the
research, we will investigate the practical effects of the time
preference theories of interest by analysing the net present
value method, which applies the theory of time preference in
its analysis of investment alternatives.
THE ROLE OF INTEREST IN FINANCIAL TRANSACTIONS
For a better understanding of the nature of interest, we will
first analyse how we commonly interact with interest. Interest
is generally linked to financial transactions. Someone taking a
loan has usually to pay interest for the possibility of receiving a
certain amount of money for a specific period of time. This
process has already been described by Adam Smith (1998) in
the following way:
"That (revenue) derived from it by the person who does not
employ it himself, but lends it to another, is called the interest
or the use of money. It is the compensation which the borrower
pays to the lender, for the profit which he has an opportunity of
making by the use of the money. Part of that profit naturally
belongs to the borrower, who runs the risk and takes the trouble
of employing it; and part to the lender, who affords him the
opportunity of making this profit. The interest of money is
always a derivative revenue, which, if it is not paid from the
profit which is made by the use of the money, must be paid
from some other source of revenue, unless perhaps the
borrower is a spendthrift, who contracts a second debt in order
to pay the interest of the first."
According to Smith, because the money lender enables the
entrepreneur to make a profit, he has the right to receive
interest payments. However, Smith also mentions that this
expense is fixed for the borrower. If the earned profit is not
enough, the borrower has to use other resources in order to
make the interest payments. But, Smith does not mention why
the lender has a right for fixed interest payments, whereas an
entrepreneur has a variable income? Keeping in mind that the
entrepreneur takes the business risk, i.e. he has no guaranteed
profit, and, in case of a partnership, he also has to manage the
company.
In order to answer the question, why the borrower has a
certain special status in financial contracts, it is necessary to
analyse the economic behaviour of borrowers. A possible
answer can be found in the "abstinence theory", which was
developed by W. Nassau Senior. According to this theory,
interest is a compensation for the delay of consumption, the
"reward for abstinence". (Gabler Wirtschaftslexikon, 2000)
Therefore, someone who saves his money and lends it, has a
right for an additional amount beyond the principal. Just as
labour is an essential input for production, in the same way it is
necessary that capitalists abstain from consuming their capital
in order to finance production. Employees receive wages for
their contribution, and money holders receive interest payments
for theirs. Thus, every contributor of a production factor has to
be compensated for their contribution. So, capitalists have to be
compensated for their abstinence from present enjoyments, i.e.
according to this theory, interest is a reward for not consuming
the whole income at once. From the aspect of time preference,
this theory assumes that individuals have a preference to
consume their income immediately, so individuals have to be
motivated to save and put part of their income at the disposal
for the demanders of money.
A similar theory to the abstinence theory is called "waiting
theory", developed by Cassel. This theory says that the
capitalist enables with his "waiting" (i.e. postponement of
consumption) the supply of money. Because this "waiting" is
scarce, the capitalist can require interest. (Gabler
Wirtschaftslexikon, 2000)
At first sight, this theory seems to be very plausible.
Without the process of saving, no financing will be possible;
but the process of saving causes opportunity costs to the money
holder. By abstaining from consumption of the whole income
at once, someone will have an excess amount of money which
he can lend to another person. So, the first question arises: why
does someone save a part of his/her income? Or in the words of
time preference: how can we induce someone to have a lower
time preference for consuming his income?
According to the abstinence theory someone saves in order
to receive the "reward for abstinence", i.e. an interest income as
a compensation for the delayed consumption and thus incurred
opportunity costs. But the questions arises, whether this is the
major reason for saving. Looking at the behaviour of
individuals, we can observe that the process of saving has
always been existing. We can see that, especially in countries
where no efficient financial system exists, people acquire gold,
jewellery or foreign currencies and sometimes dig them into
the earth in order to have purchase power in the future. (El
Naggar, 1981) This behaviour is also a type of saving, because
individuals delay their consumption for a future period, but
such savers do not receive any interest on their stored wealth.
German-Argentine economist Gesell (1949) stresses that the
saving process can be observed in the nature at the behaviour
of animals, which accumulate food in advance, but certainly do
not receive any interest on their savings. And finally, empirical
evidence presented by Stiglitz (1999) shows that savings are
inelastic towards interest rates, so interest rates do not have a
high impact on the level of savings. Therefore, it is necessary
to search for other reasons for saving.
Starting from the above arguments, it is obvious that the
process of saving is related with the desire to have enough
money for future expenses (e.g. for marriage, retirement,
expensive products). Sometimes people do not intentionally
safe, but simply have temporarily higher cash inflows than
outflows. Especially for millionaires and billionaires we cannot
say that they save for a reward; but simply because they have
more money than they need. Furthermore, as Gesell (1949)
explains, the process of saving is a natural process, which has a
"security effect", i.e. protection against future unexpected
expenses.
Nobel laureate Modigliani maintained that an individual
saves for his retirement, in order to have enough money for
consumption during retirement. He called this saving motive
"life cycle saving". (Stiglitz, 1999) On the other hand, Milton
Suad Bećirović / University journal of Information Technology and Economics / Vol.2 (No.1) / June 2015 / pp. 5-13
Friedman said in his "permanent income hypothesis" that
expectations about the future influence the consumption of
individuals. Individuals save in good times in order to be
prepared for bad times. So, the permanent income is the
average income of an individual during his whole life. (Stiglitz,
1999) The difference between these two theories is that
Friedman's theory suggests that the role of saving is to smooth
out consumption between good and bad years, whereas
Modigliani says that the role of saving is to smooth out
between consumption in active years and retirement. (Stiglitz,
1999)
Analysing all theories and obvious behaviour of
individuals, the first conclusion is that the process of saving is
independent from the possible reward of interest. This
observation has already been mentioned by Keynes in his
famous "General Theory of Employment, Interest and Money"
(2003) when he said: "It should be obvious that the rate of
interest cannot be a return to saving or waiting as such. For if a
man hoards his savings in cash, he earns no interest, though he
saves just as much as before. On the contrary, the mere
definition of the rate of interest tells us in so many words that
the rate of interest is the reward for parting with liquidity for a
specified period. For the rate of interest is, in itself; nothing
more than the inverse proportion between a sum of money and
what can be obtained for parting with control over the money
in exchange for a debt for a stated period of time."
A further simple example explains this argument: if it was
true that interest is a reward for abstinence of consumption then
everybody who saves money at home, e.g. in a safe, should
also receive interest. But the fact that only a person, who lends
his savings, receives interest shows the important link between
interest and the process of lending, as already mentioned by
Smith in the introductory example. However, we will not
investigate this point anymore and return to analysing the
correlation between time preference and interest.
INTEREST AND TIME PREFERENCE
The previous section has shown that individuals save
money for a certain purpose. Thus, we can even say that
many individuals have a lower time preference, because
they delay their consumption to finance their future
expenses. In the following, we will compare this thesis with
major time preference theories of interest.
The delay of consumption, which is mentioned by the
abstinence theory, does not only cover the aspect of saving,
but also the aspect of "time preference", because it is
assumed that individuals prefer consumption now, in
conditions of certainty, to consumption in an uncertain
future. This effect of time preference was further developed
by Austrian economist Eugen von Böhm-Bawerk in his
"agio theory". Von Böhm-Bawerk supposed that people
underestimate their future needs, so one product has less
value tomorrow than one product today. Saving, or the delay
of consumption today, will only occur when the value of
possible future consumption will be higher than the value of
the present consumption. This percental increase (agio) is
interest, a reward for saving or the supply of money. (Gabler
Wirtschaftslexikon, 2000)
Similar to the agio theory is the neo-classical "discount
theory of interest". In fact, this theory has a similar
argumentation as the agio theory and claims that "present
goods are, as a rule, worth more than future goods of like
kind and number; that is, goods which are available for use
now are worth more than the same quality and quantity of
goods which will be available for use a year or five years or
ten years from now." (O'Hara, 1919)
According to these theories, the decision of individuals
about the postponement of consumption is executed with
regard to their rate of time preference. Thus, richer
individuals will have a lower rate of time preference, and are
certainly readier to postpone their consumption, whereas
poorer people will have a high preference, because they
have to finance their everyday needs. However, the question
arises whether this delay of consumption is caused by "time
preference" or due to other reasons, such as an excess
amount of money in a certain period of time.
We can say that with regard to time preference,
individuals have a subjective appraisal depending on their
living conditions. It can be assumed that younger people
have a higher time preference and rather think form today to
tomorrow, as the agio theory suggests. Generally, it can be
said that the propensity to consume is higher for younger
individuals, because they want to fulfil certain desires (e.g.
buying certain products, founding a family) and for this goal
they are even ready to become indebted. On the other hand,
for elderly people, it can be assumed that they have achieved
their major consumption desires and reduce their
consumption. But, as shown in the previous section, it seems
that people have the inborn habit to have a certain money
reserve for unexpected expenses, or for retirement. Thus, it
has to be considered that generally people will consider
some kind of expectations in their consumption plan. The
following example by El-Naggar (1981) shows the role of
expectations for consumption decisions: At the beginning of
the 1960s, the government of Egypt introduced profit-
sharing schemes for employees. After the first distribution
of profits, more than 50% of the employees stayed away
from work for some days. The unexpected (italics by author)
profit distribution induced employees to buy intoxicants or
other drugs; and some used the opportunity to marry.
It is obvious from this example that the unexpected
income for employees caused a high time preference,
because people think that the increase is short in nature.
Furthermore, it has to be considered und which
circumstances a certain decision was taken. Behavioural
economists would say "the frame" has to be considered. In
the above example, it has to be kept in mind that these
Egyptian workers in most cases stemmed from poor rural
areas and therefore were not familiar with a high standard of
living. But then they lived in a city, e.g. in Cairo, which
offered different consumer goods to these people, they could
have never imagined. With their usual lower income, they
Suad Bećirović / University journal of Information Technology and Economics / Vol.2 (No.1) / June 2015 / pp. 5-13
were only able to finance their basic needs and savings had
to be sent to other family members in their poor region of
origin. Apparently these people used their unexpected
additional income to fulfil some of their dreams.
Furthermore, it has to be considered that low income groups
often have to take loans or ask for state assistance in order to
finance their consumption, so unexpected income increases
will be used to repay debts. Therefore, it can be claimed that
for lower income groups consumption is only dependent on
the current income, because these groups do not enough
money to save, e.g. for retirement, and not due to a lavish
lifestyle.
On the other hand, positive expectations about the
economic development in a stable environment can lead to
higher consumption in younger years, due to a certain
degree of security. For example, if individuals assume that
their pensions are secure, they will not save additionally for
retirement. However, if they believe that the system of
pension insurance is unstable, they will save an additional
amount (e.g. by concluding a private pension insurance or
by making investments on the stock exchange).
An important factor with regard to saving and
consumption is the social environment in which a household
lives. It can be observed that households tend to imitate each
other. (Blum, 2004) Therefore, there is sometimes a kind of
"forced" consumption in order to justify a certain social
position or people temporarily consume more due to
customs (e.g. high expenses at funerals or circumcision
celebrations). Sometimes these expenses are "irrational",
however in order to keep a personal image, people pay much
money (or become indebted) in order to reach a certain
status in the society. So, it can be observes that relatively
poor people spend much money in order to have an
expensive marriage for their child and even become
indebted.
The same applies in countries with an intensive
"consumer culture", where e.g. credit cards are massively
used to finance consumption, which lead to high debts for
households. These debts have to be returned over a long
period and sometimes these households even cannot return
these debts. Some economists believe that credit card
spending has played a significant role in the decline in U.S.
savings. (Akerlof & Shiller, 2009) On the other hand, Asian
nations, such as China, Malaysia and Singapore have one of
the highest saving rates in the world due to an institutional
environment, which supports a "saving culture".
This short overview shows that saving largely depends
on "institutional and mental frames" (Akerlof & Shiller,
2009), which lead to different expectations. Whether people
will consume their whole income or be able to save is of
very subjective nature, but certainly the interest rate plays a
minor role.
Up to now, only the demand side for money has been
analysed according to agio theory. Another question is: why
does the value of money increase with the process of saving
(hoarding)? Von Böhm-Bawerk compares the increase of
the value of money with that of wine. Because vine
increases its value with time, the value of every stored asset
will increase over time. (Gesell, 1949) However, as Gesell
(1949) rightly argues, if this assumption is true, then we
have only to produce goods in stock once and by storing,
their value will automatically increase over time. So, people
could live from the income of these goods, because they
become better and more expensive every year without any
additional work. However, every entrepreneur avoids
producing goods in stock, because the value of goods in
stock decreases over time - they are either rotting or their
will be no demand for this product over time due to
technical progress or a change in consumer preferences.
Furthermore, it has to be considered that wine is not a
finished product. The raw product, the grape juice, is taken
into the drum and has still not reached the level to be ready
for sale. It becomes wine step by step through the process of
brewing. Through this natural process, wine becomes a
finished product and thus increases its value, and not by the
process of storing. (Gesell, 1949)
So, we can sum up that time preference theories of interest
are quite incomplete with regard to the explanation of the
existence of interest. However, these theories point to the
fact that there will always be people with an imbalance of
wishes and real possibilities, which causes a continuous
demand for loans. In order to satisfy this demand, it is
necessary to have savers, who are willing to lend their
money. This savers will ask for a certain interest rate,
according to their "time preference", or better to say
according to market circumstances, credit worthiness and
other factors. So, it seems that time preference, and
consequently the discounting of cash flows, is rather the
effect of the existence of interest, than the cause for the
existence of interest.
CONSEQUENCES OF TIME PREFERENCE IN THE BUSINESS
ENVIRONMENT
The above theoretical discussions about time preference
theories of interest have practical consequences on the thinking
of businesspersons. When an entrepreneur wants to make an
investment, he/she will compare the return of this investment
with possible returns of alternative investments, usually risk-
free interest-based investments. In other words, investors will
always discount their future cash-flows with certain "secure
interest rates" of interest-based financial products, which they
can receive on the capital markets. So, the real reason for
discounting the future is that people are able to receive positive
interest rates on their savings.
In practice, the discounting of cash flows is done by the so-
called "net present value method". This method sums up the
present values of cash flows of a certain investment and after
deducting the acquisition costs for the investment, we receive
the so-called net present value. Present values of cash flows are
used, because the generated cash flows of a certain period can
be used for other investments in the meantime. The earlier the
cash flow occurs, the higher the potential return from this cash
Suad Bećirović / University journal of Information Technology and Economics / Vol.2 (No.1) / June 2015 / pp. 5-13
flow. So, when an investor uses the net present value method,
he/she, in fact, compares the cash flows of an investment with
the return of interest-based financial products (e.g. government
bonds or saving accounts). If the investment has a positive net
present value, this means that the investor will receive a higher
return on his investment, than putting his money on the
interest-based financial product. On the other hand, a negative
net present value means that the investment is not able to earn
the specified minimal interest, which the investor can receive
from the interest-based product.
INTEREST RATE AS AN ENTRY BARRIER FOR INVESTMENTS
Mathematically, the net present value is calculated
according to the following formula:
where:
NPV = net present value
CF = net cash flow during the period t
t = number of time periods
i = interest rate (minimal return)
A0 = Acquisition Costs in period 0
The formula shows that the investment will be only conducted
if the sum of the discounted cash flows is higher than the
invested capital. This is especially interesting when we use the
net present value method for investments in the real sector. If
capital markets offer high yields with fixed income securities,
then investors will not conduct real investments. Thus,
investments will decrease, which will lead to a shift in
economic activity from the real sector to the financial sector.
Real sector investments will become feasible again at
decreasing interest rates. But in the meantime, firms of the real
sector will decrease their economic activity, which will lead to
a rise in the unemployment rate. Therefore, the discount rate is
the entry barrier for investments for a company. The higher
the discount rate, the lower the possibility investments will be
conducted. So, not only increasing costs for interest (in case of
high interest rates) are the reason for decreasing investments,
but companies will invest more liquidity in the capital markets
than in investment projects in such a case. For example, well-
known German company "Daimler-Benz" had during the high
interest rate period in Germany in 1981 earned a profit from
interest-based investments of about 610 million DEM, but
would have had a loss of about -306 million DEM, without
this income. (Daimler-Benz Geschäftsbericht, 1981)
Therefore, companies with high liquidity reserves can have a
competitive advantage over other companies due to their
interest income, which can lead to a change in production
preferences.
In a closed economy we can assume that an increase in
savings will lead to a fall of interest rate and thus real
investments will become feasible again due to the falling
discount rate. On the other hand, in an open economy, due to
the greater possibility to invest savings, the fall of interest
rates will be slower, so the motivation for real investments
will fall. Here, also another point has to be considered,
increasing competition in globalised markets lead to a falling
profitability, especially for small and medium enterprises.
This decreasing profitability causes that more and more
entrepreneurs are not willing to take risk and therefore prefer
risk-free income from interest.
Figure 1: Development of interest rates for savings
deposits with an agreed maturity of 12 months in
Germany
Source: Deutsche Bundesbank
It could be assumed that the long-term accumulation of money
savings will lead to a reduction in interest rates, which will be
positive for economic development. However, a look at the
development of interest rates shows that interest rates never
fall to 0%, contrary to other prices. For example, figure 1
shows the development of interest rates for savings deposits
with an agreed maturity of 12 months in Germany for the
period from 1967 to 2003. The reason for not including newer
data is that since 2004 Deutsche Bundesbank uses the
methodology of the European Central bank, so numbers
cannot be compared adequately. But, it can be seen that
interest rates are always above 1 percent, despite a continuous
decline since 2000. This shows that interest rates have to be
positive in order to attract savings.
The reason for such a development of interest rates is that
money, as general accepted medium of exchange, has the
advantage that someone is able to buy and pay without any
problems, which is not the case with other goods, e.g. bonds
or bills of exchange. Furthermore, the flexibility of money
leads to flexibility in the choice of goods and services offered
in the market. Therefore, people prefer to possess money, i.e.
they have a "liquidity preference", as it is called by Keynes.
However, when someone lends money, he transfers these
advantages for a certain period of time to the borrower. For
this service, i.e. the transmission of the advantages of money,
the money holder asks for interest, in order to compensate his
temporary disadvantage. Due to the received advantage of
having money, the borrower is willing to pay interest as a
price for borrowing money. Therefore, Keynes (2003) calls
interest a reward for parting with liquidity.
The decision about borrowing or holding money is, according
to Keynes, made according to the subjective appraisal,
Suad Bećirović / University journal of Information Technology and Economics / Vol.2 (No.1) / June 2015 / pp. 5-13
whether the current interest rate is temporarily adequate. If
money holders think that they can earn an adequate return by
lending at a certain interest rate, then they will lend their
money. On the other hand, at lower interest rates money
holders are not ready to part with their money and hold cash or
change their investment portfolio. The reason for such
behaviour is that ownership of money does not cause
"carrying costs". A similar argumentation to Keynes', can be
found by German-Argentine economist Gesell. Gesell insists
that there is a major difference between money and all other
goods. Looking at physical assets, it can be observed that each
of them has its particular enemy: for furs, it is the moths; for
glassware the breaking, for iron the rust, for animals, diseases
of all kinds, and besides these individual enemies, there are
common enemies for all the goods – water, fire, theft, etc. So
the question arises: how can the owners protect themselves
against such losses? The only solution is that they will sell
their goods as soon as possible. In order to sell his goods, the
seller has to offer them. Here, it has to be considered that new
goods and services arrive continuously on the market, e.g. the
cow gives milk every day, people have to work every day.
(Gesell, 1949) Therefore, if the seller is unable to sell his
products, he will reduce the prices in order to foster the sale of
the product. Thus, Gesell concludes that: "One can say,
without encountering any contradiction that the supply is
subject to a powerful, everyday growing, all obstacles
overcoming, in the material containing compulsion, a
compulsion which is appended naturally to the things offered.
The offer cannot be delayed. Regardless of the owners' will,
the goods have to be offered on the market every day."
(Gesell, 1949) So, if a store owner closes his store with all
goods inside for a year, after this period he will have to throw
away almost all of the goods which were inside. In addition,
he has to pay rents and taxes for the store. But this situation
does not apply for money holders. Gesell (1949) says: "The
demand is, on the other hand, as I said before, free of such
coercion. Produced of gold, of a precious metal, which, as its
name implies, has an extraordinary position among earthly
substances and, so to speak, can be seen as a foreign substance
of this earth, (because) it resists victoriously all forces of
nature. Gold does not rust and not fault, it does not break and
does not die. Frost, heat, sun, rain, fire – nothing can hurt it.
The money, we make from gold, protects its owner against
any material loss."
This protection enables money holders to control the supply of
money, because they can store their savings without any real
costs.
1
Money holders do not have to fear losses due to
perishing and they do not have to fear they will lose
customers, because they own the general accepted medium of
exchange. So, if they hoard (store) money and want to lend it
for a specified interest rate, they will find enough customers
1
Of course, we have inflation as a real holding cost for money.
However, savers usually hold their savings in the form of "stable"
values and especially calculate the anticipated rate of inflation into
the asked interest rate from borrowers.
who are willing to pay the interest. The monopoly status of
money holders can be observed at low interest rates. When
interest rates are low, money holders can withdraw their
savings from the capital markets. Although they will lose their
interest income in such a case, withdrawal enables an increase
in interest rates and hoarding does not cause any real
expenses. The lack of costs of hoarding causes that money
holders can always ask for a positive interest rate.
Furthermore, in today's globalised world economy, savers can
to transfer their savings to other countries. Thus, demanders
for money have always to offer a positive nominal interest rate
in order to receive their necessary funds.
INTEREST RATE AND THE USE OF RESOURCES
A detail analysis of the net present value method shows that
the application of this method will lead to a change in
investment preferences. As the formula mentioned above
shows, the net present value formula is based on four
variables:
Net cash flows
number of time periods
interest rate (minimal return)
Acquisition Costs
Analysing the formula mentioned above, we can see that it is
better to have high cash flows at the beginning of the
investment period, because their present value is higher, i.e.
the earned money can be invested at an earlier period, which
will increase the investor's wealth. In order to show this
behaviour, we will compare three different hypothetical
investments with the following cash flows:
Alternative
Cash flows
Period
1
Period
2
Period
3
Period
4
Period
5
A
10
20
30
40
50
B
50
40
30
20
10
C
30
30
30
30
30
Table 1: Cash flows of three different hypothetical
investments
As table 1 shows, alternative A has a progressive increase in
cash flows, whereas Alternative B has decreasing cash flows.
Alternative C has constant cash flows over the period. As it
can be seen, the average of all cash flows is the same and the
used numbers for alternative A and B are the same, but in an
inverse order. Moreover, we assume acquisition costs of 100
and a interest (discount) rate of 10%.
Alternative
Net present
value
Internal rate
of return
Total
investor
wealth
A
6.53
12%
171.56
B
20.92
20%
194.75
C
13.72
15%
183.15
Suad Bećirović / University journal of Information Technology and Economics / Vol.2 (No.1) / June 2015 / pp. 5-13
Table 2: Net present value, internal rate of return and
total investor wealth of three different hypothetical
investments
Comparing the three cash flow distributions, we can see that
alternative B has the highest net present value, because high
cash flows are generated at the beginning of the investment
period. The possibility to invest these cash flows again
increases the value of the investment. So we receive an
internal rate of return of this investment of 20%. Alternative C
is the second best investment in this hypothetical example.
The investment has the same cash flows, but present values
are decreasing, so the internal rate of return is at 15%.
Because alternative A has higher cash flows at the end of the
investment period, net present value of this investment is the
lowest, because the period of reinvesting the generated cash
flows of this investment is the shortest.
Another major point in this discussion is the question about
total investor wealth. Net present value method suggests that
the earned cash flows during the period will be invested again
at the same interest rate. In this case, we have to use the
following formula for calculating the total investor wealth at
the end of the investment period:
The reason for subtracting the exponent is that the net present
value assumes that cash flows occur at the end of the
respective year. As we can suggest, alternative A leads to the
highest wealth. But it is important to mention that we always
have the alternative to invest the initial capital at an interest
rate of 10%.
The first alternative our investor has in this hypothetical case
is to put in the initial capital for 5 years at 10% interest
compounded annually at the end of each year. In this case the
investor will have a total wealth of 161.05. However, the goal
of the net present value method is to have investments that
lead to a higher investor wealth.
But, what we can learn from this example? These three
distributions show that investors will probably prefer
progressive cash flow distributions, in order to have a
maximum generated wealth of their investments. So, it can be
assumed that investors will execute investments with a
digressive distribution of cash flows. On the other hand, if
cash flows are of progressive nature over the time, especially
if there are negative cash flows at the beginning of the
investment period, cash flows of later periods have to increase
exponentially in order to reach higher present values. For
example, if alternative A had wanted to achieve the same
internal rate of return as alternative B, it should have cash
flows of 60 and 80 in the fourth and fifth year respectively.
So, long-term investments have to generate high cash flows in
the future in order to be carried out. Moreover, we can see that
investments with constant cash flows will not be quite
popular, because the present values of this investment
decrease over time. For example, offering relatively constant
dividends to shareholders will not be very attractive for
investors, due to a lower net present value of such an
investment, on the condition that investors will hold such
shares over a longer period of time. Generally, we can say that
the thinking of time preference illustrated by the net present
value method implies high cash flows (profits) as soon as
possible in order to execute investments. Therefore, it is
necessary to use resources at a maximum. The following
example shows this. We assume that an individual owns
productive land, which he can manage with the following
alternatives:
1. Using the land intensively for 20 years and receive a
cash flow of 13,000 in the first year and in the
following years cash flows decrease by 10%
annually. However after this period, the land cannot
be used for productive purposes anymore.
2. The other alternative is the sustainable use of land
with an annual cash flow of 6,000, where the land
can be used "indefinitely".
The acquisition cost of the land is 50,000 and the investor
calculates with an interest rate of 10%.
According to these assumptions the first alternative has a net
present value of 13,825, whereas the second alternative has a
net present value of only 10,000. If the investment decision is
exclusively made according to the net present value, the first
alternative will be chosen. However, using this alternative, the
land will be unusable after 20 years, so future generations will
not be able to use this land anymore and have income from it
due to intensive usage. On the other hand, the second
alternative would generate an eternal cash flow and future
generations could use the land. However, discounting says that
higher cash flows at an earlier stage have to be preferred, so
extensive exploitation of resources is fostered, because these
cash flows can be invested and receive an interest income.
Such thinking leads to damages of the environment,
exploitation and to selfish behaviour, without considering the
interests of future generations. Thus, thinking according to net
present value leads to an investor behaviour where the distant
future is discounted excessively relative to the near future.
This is the real reason for time preference, receiving high cash
flows as soon as possible to reinvest or consume the earned
money as soon as possible.
INTEREST RATE AND THE FUTURE DEVELOPMENT OF AN
ECONOMY
The net present value method assumes that generated cash
flows will be invested again at the used interest rate. Therefore
this method uses the assumption that there will be always a
demand for money at this interest rate. This is possible at
growing economies with a small stock of capital. But when the
stock of capital increases, the question arises how to attract
savings. If interest rates fall, investors do not have the
motivation to invest their money on capital markets and
therefore they will either hoard, speculate or invest their
savings in foreign financial markets. Now, the question arises
Suad Bećirović / University journal of Information Technology and Economics / Vol.2 (No.1) / June 2015 / pp. 5-13
how this "excess liquidity" can be mobilised in order to
increase aggregate demand in the economy. Keynes (2003)
proposed that the government should create an additional
demand at economic crises. Keynes said that "even a diversion
of the desire to hold wealth towards assets, which will in fact
yield no economic fruits whatever, will increase economic
well-being. In so far as millionaires find their satisfaction in
building mighty mansions to contain their bodies when alive
and pyramids to shelter them after death, or, repenting of their
sins, erect cathedrals and endow monasteries or foreign
missions, the day when abundance of capital will interfere with
abundance of output may be postponed. ‘To dig holes in the
ground’, paid for out of savings, will increase, not only
employment, but the real national dividend of useful goods and
services."
So, Keynes suggests that any investment which is able to
mobilise savings is good in order to boost the economy and
decrease unemployment. According to Keynes, only a small
impulse would be necessary, due to the "multiplier-effect". The
multiplier causes that the money spend for investments will
generate income for the producer, its suppliers etc. and
therefore will increase income much more than the amount
originally spent. However, Keynes did not consider that these
government interventions are not one-time interventions, but
interventions, which are of dynamic nature, which have to be
conducted regularly in a certain time frame. So, the dynamic
thinking of investors by using the net present value method
causes a dynamic government intervention, where the
government has to act, over the long haul, continuously. Thus,
the long-term consequence of government interventions are
rising public debts, because in times of economic crises public
revenue decreases due to a decline in economic activity,
whereas expenditures rise due to higher social expenses and
government interventions (e.g. subsidies). When the economy
recovers, the revenues rise again and should be used for
repayment, but the problem is that expenditure do not fall
simultaneously with economic recovery, because granted
subsidies or long-term investment projects cannot be cancelled
easily.
But, when we return to Keynes' proposals, where many
different public investments, such as the construction of
religious institutions or other mighty and expensive buildings,
are suggested, we can see that the "time-preference" of
investors in an interest-based financial system can lead to the
construction of objects, which future generations can use and
enjoy. So, in order to keep the interest-based system going, i.e.
to keep the interest not too low, from the savers' perspective,
but not too high from the perspective of entrepreneurs, it is
always necessary to have an ongoing demand for money.
CONCLUSION
This analysis shows that the existence of interest is not
directly related to the time preference of individuals.
Individuals have certain expectations and according to these
expectation they organise their consumption. The negligible
influence of time preference with regard to the existence of
interest can be seen in analysing the behaviour of millionaires
and billionaires: why do they avoid spending their whole
income at once? Certainly not, because they have a low time
preference, but because they have fulfilled their basic needs
and are able to invest their excess money. Especially the
phenomenon of greed cannot be explained by time preference,
but other explanations are needed for such behaviour.
The special characteristics of money, as the general
medium of exchange, enable money holders to offer their
product at a special price. Thus, investors in an interest-based
financial system can choose whether they want to invest at
interest-bearing accounts with a certain interest rate, or to
invest in riskier alternatives, which exceed this minimal return.
This is, in fact, how the modern financial system based on
interest works. But, it is often neglected that interest, due to
compound interest effect, grows exponentially. However, no
economy is able to grow without limits, because every resource
in this world is limited. Therefore, such a system is not
sustainable on the long-term and has inevitably lead to
economic crises. The enormous amounts of saved money based
in today's developed economies have to be employed and
therefore new markets and new financial products have to be
developed in order to attract these savings. But, as we can see
today, this system works on the expense of the majority of the
world population. Therefore, in the first step it is necessary to
question today's normative economics. For example, in every
textbook about investment and finance today we can find the
net present value method. But only a small number of critical
texts with regard to this and other standard economic methods.
This paper should be seen as a first step for such a critical
analysis and a motivation for developing alternative
approaches to finance and investment.
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