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38 Tax L. Rev. 565 (1982-1983)
The Miracle of Compound Interest: Interest Deferral and Discount after 1982

handle is hein.journals/taxlr38 and id is 575 raw text is: The Miracle of Compound Interest:
Interest Deferral and Discount After 1982
Money has a time value, generally expressed as interest. The right to
$1 today is more valuable than the right to $1 one year from today, by
the amount that could be earned by investing $1 for one year. If interest
is not paid as it accrues, the amount to be received or paid in respect of
a loan normally increases at a compound rate, reflecting the fact that,
since interest received currently is available for reinvestment, interest
earned but unpaid should earn interest until paid. The compounding of
interest may have great cumulative impact. For example, at 15 percent
interest compound annually, $100 grows to $6,621 in 30 years. At 15
percent simple interest, by contrast, $100 grows to $550 in 30 years.
The difference of $6,071 is interest on accrued but unpaid interest.
In the world of business and finance, compound interest normally
accrues on an economic, actuarial, or constant interest basis.' A
debt obligation-or, for that matter, any predictable stream of cash
flows-is valued in the financial marketplace by reference to its yield to
maturity or present value. While there are elaborate variations on each
of these concepts (such as an investment's internal rate of return), they
all rest on the compounding of interest. Moreover, in valuing financial
instruments, analysts do not distinguish payments denominated in-
terest from those called principal unless the distinction has legal
ramifications that may have economic effect, ramifications, for ex-
ample, on prepayment, in bankruptcy, or for tax purposes. Apart from
these legal considerations, the financial analysis of yield is purely mathe-
matical: Identical payments due at the same time are valued equally,
* PETER C. CANELLOS is a partner in the New York City law firm of Wachtell,
Lipton, Rosen & Katz. EDWARD D. KLEINBARD is an associate with the New York
City law firm of Cleary, Gottlieb, Steen & Hamilton.
1 These three terms are here used synonymously.
2 See, e.g., Krane, Economic Analysis of Tax Shelter Investments, 54 TAXMS 806
(1976); Note, Interest and Principal: A Failure of Definition in the Internal
Revenue Code, 72 YALE L.J. 200, 203 (1962); Goldsmith, Capital Budgeting for
the Individual Investor, and The Financial Tables: Their Construction and Use,
reprinted in EVALUATjNG TAx SaELTER OFnFEMUGS 1982 (A. Rosenberg, ed.).

Imaged with the Permission of N.Y.U. Tax Law Review

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