The answers to these questions can be found by answering some other questions, like for example:

• Do we care if the buyer pays us the agreed amount (eg €10.000,00) today or in 3 years? Of course we do, because if other conditions remain unchanged, we would prefer to have the money sooner rather than later. With this money, we could repay a short-term loan and reduce the cost of financing, or we could invest it in business activities or financial investments and have some returns on those investments.

• Do we have to pay a larger amount to the bank at the maturity of the loan if we borrow money for 3 or for 12 months? We must, of course, pay more interest on the borrowed amount if we borrow money for 12 months rather than 3 months, despite the possibly same annual interest rate in percentage.

• When do we get a greater amount of money when the savings plan come to an end: if the money is bonded for 1 year or 5 years? After five years, we would get a repaid principal and a larger amount of interest compared to one year, despite the possibly same annual interest rate.

 Money is therefore not free, but it has its own price; the price of money is the interest rate, where time is an important factor (borrowing, bonding, investments ...). We cannot compare money at different time points directly to each other. We cannot just say whether it is better to choose a € 110 payment in 3 months or € 115 after 6 months. For the comparison of monetary amounts at different time points, we have to set the amounts to the same time point, which we do by discounting (and calculating the present value) of monetary amounts or by setting (and calculating the future value) of monetary amounts.

The price of money has a practical impact on all areas of the self-employed person's activity. First, it reflects on long-term costs of capital or on the cost of debt financing and capital financing. In fact, the higher the price of money, expressed in terms of Weighted Average Cost of Capital (WACC), the higher the operating income after taxes must be (without taking into account the effects of financial investments). The same applies to any long-term financing decisions, where the WACC is a key parameter used to evaluate the sensibility of investment projects. The price of money can, under certain conditions, also influence decisions relating to the financial structure of the company.

The cost of money, which takes the name of interest rate, is also equivalent to the opportunity cost of keeping the money necessary for the business of the company in liquid form and the increase in the rate leads to an expected reduction of the money in the business account (other things being equal). The price of money also affects the management policies of stocks and loans to customers and the policy of financing short-term investments. For further information on the consequences of the cost of money on individual business decisions, please refer to the sections dedicated to the specific topics.

As we have already seen in the section Is money free? it is not possible to directly compare the amounts of money (income or expenses) that occur at different times. Therefore, if we want to correctly analyze decisions, policies and commercial strategies, we must also consider the factor of the temporal value of money. The temporal value of money, which in this case is given by the average cost of capital (WACC), mainly affects investment choices. These typically have a very long life cycle and bring money out of the company at the beginning of the investment, making it return only to the next phase. Clearly, it is not indifferent if the cash flows begin to enter immediately after the investment is made or after a much wider period of time has passed, as the sums of money that the company should receive in the future take on a lesser current value when they are distant in time. So if we find ourselves having to choose between two investments that will yield the same cash flows in the future, but with the difference that the first investment will start to bear fruit shortly after the investment is made, while the second will start to bear fruit just after a few years. It is clear then, that the first investment opportunity is the most sensible. In other cases, more detailed calculations are required, for which see the Investments section.

Source: Dolenc, P. & Stubelj, I. 2011. Poslovne finance s praktičnimi primeri. Ljubljana.

Interest rates are subject to change and are never constant over time. In general, we can say that there are many different interest rates on the financial market, which are however interconnected and move in a more or less similar way. Interest rates are defined through the monetary policy implemented by the central bank (in the Eurozone by the ECB - European Central Bank). The ECB interest rates therefore perform the function of base rates, on which all others rest. Rates are usually defined on the basis of market principles and are not established directly by the central bank, even if they are still heavily influenced (for example rates increase when the ECB raises its rates and drop when the ECB lowers them). However, trade rates are much more volatile than ECB rates and in most cases change throughout the day.
The rates on a loan for the company naturally depend on the nature and purpose of the loan, as well as on factors at the level of the money market (macro) and at the level of the enterprise (micro). The former include the central bank interest rate (base rate), the perception of general risk, the expected return of an average investment on the market, etc. Among the micro factors, the risk (i.e. instability) of the company, the type of transaction (the rate on deposits is different from the rate on mortgages), the duration of the transaction (e.g. the bond period of the deposit), money market liquidity and so on. As an example, we report below the EURIBOR interest rate, which often appears in credit agreements and its performance is closely linked to the trend of interest rates within the company. The figure shows the performance of the six-month EURIBOR for the year 2014 and it is clear that the rate changes daily, while long-term rates have, for obvious reasons, greater stability.
 

Figure: EURIBOR 6M trend, 2014

 

Source: http://www.euribor.org/euribor-org/euribor-rates.html