What is the primary purpose of interest in the context of time value of money equations?

• A. To compensate lenders for the opportunity cost of lending their money over time
• B. To increase the principal amount of a loan
• C. To reduce the risk of default for borrowers
• D. To calculate depreciation of fixed assets

Answer: (A)

Verified step by step guidance

1. Understand the concept of interest in the context of the time value of money. Interest is the cost of borrowing money and serves as compensation to lenders for the opportunity cost of lending their funds instead of using them elsewhere.
2. Recognize that the time value of money is based on the principle that money available today is worth more than the same amount in the future due to its earning potential. Interest is a key component in quantifying this earning potential.
3. Eliminate incorrect options by analyzing their relevance to the concept of interest. For example, 'To increase the principal amount of a loan' is incorrect because interest does not directly increase the principal; it is a separate cost added to the principal.
4. Similarly, 'To reduce the risk of default for borrowers' is incorrect because interest does not directly address default risk; it compensates lenders for the time value of money.
5. Finally, 'To calculate depreciation of fixed assets' is unrelated to interest, as depreciation pertains to the allocation of the cost of tangible assets over their useful life. The correct answer is: 'To compensate lenders for the opportunity cost of lending their money over time.'