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MBA Class; Time Value of Money in Financial Decision Making

By in Advanced Investing, Automatic Saving, Bond, Investing | 10 comments

Make the Time Value of Money Work for You

“A bird in the hand is worth two in the bush”

This medieval proverb still holds true today. In modern terms, it’s better to have a certain payoff today than an uncertain one in the future. After all, who knows what the future holds? By grasping net present value, you can find out how to hack the time value of money concept for your own benefit.

Net Present Value-How to figure out the time value of money.  

What if someone offered you $10,000 today or $10,000 in three years?

Of course you’d take the $10,000 today. In fact $10,000 received today is actually more valuable than $10,000 received in three years because:

You don’t know whether inflation will damage the purchasing power of the $10,000.

You can invest that $10,000 to make more money. Thus, if invested wisely, you will have more than $10,000 in three years.

This example is a “no brainer”. But what if someone offered you $10,000 today or $12,000 in three years, which would you choose?

The answer is, it depends. It depends upon what return or interest rate you might earn on that $10,000 in the next three years. And that’s where some smart financial projecting comes into play.

Imagine you can have $10,000 today or $12,000 in three years. Which would you choose?

To help with your decision, you must project what type of return you can earn on the $10,000 if you invested it for the next 3 years.

Let’s assume you can buy a zero coupon bond paying 5 percent interest maturing in three years.  Take the $10,000 today and invest it in the three year zero coupon bond paying 5 percent interest, the future value of the bond will be $11,576.25.

Now let’s discount the value of $12,000 received in three years back to today, using the same 5 percent interest. That $12,000 received in 3 years is worth $10,366 or $366 more than $10,000. Thus, at a discount rate of 5 percent rate, you are better off choosing the $12,000 in three years over the $10,000 today.

Now, if you could earn more than 5 percent on the $10,000, your decision making would change. If interest rates went up to 7 percent and you could buy that same 3 year bond with a return of 7 percent, your future value would be $12,250 (in three years). And the $12,000 discounted back to today at 7 percent would be worth only $9,796. Thus, at a higher interest (discount) rate, you are better off choosing the $10,000 today.

Lump Sum Payout versus Annuity

The net present value concept can also help you determine whether a lump sum payout or annuity (monthly payments) is a better option. The answer lies in which choice gives you a larger net present value or value today.

What if you have the choice of receiving $10,000 per year for 10 years or $100,000 today. Well clearly, like the prior example, you would take the $100,000 today because you can start investing that money immediately. But what if you were offered $80,000 today or $10,000 per year for the next 10 years. This choice is not so easy.

Let’s see what happens if you project the discount rate at 7 percent and believe that you can earn 7 percent on the future cash flows of $10,000 per year. With our net present value calculator (from Investopedia or any number of other online sites) the $10,000 received for 10 years and discounted back at 7 percent is worth $75,152 today. Compare that $75,152 with $80,000 received today and you would be better off taking the $80,000 lump sum payment today.

Remember, if expected interest rates change, so will the net present value.

Using Future Value Discounted Cash Flow for a Car Buying Decision

This is a method to find today’s worth of future income. We just used discounted cash flow to determine what a future amount of money would be worth today. Businesses use this method to analyze future project. Investors use this to value securities. and you can use this metric to figure out the true time value of money.

You might use this strategy to figure out whether to spend today or save for the future.

Let’s say you have a choice between buying a $15,000 car or a $25,000 car. Hypothetically, assume you are paying cash. Take the difference of $10,000 and imagine you bought the $15,000 car and invested the $10,000 in an investment which will earn 6 percent per year for the next ten years. In 10 years you will have a $15,000 car that’s probably worth $2,500 plus the invested $10,000, which will be worth $18,194.

Had you bought the $25,000 car, in ten years you have a ten year old car worth about $3,200.

Scenario one is worth $20,694 ($18,194 + $2,500).

Scenario two is worth $3,200 (the depreciated value of the $25,000 10 year old car).

This is an “in your face” example of the trade-off between saving in spending. You decide if the more expensive car is worth $17,494 ($20,694-$3,200) more than the $15,000 model.

 Action Step

Use a future value calculator to figure out how much saving today will be worth in the future. Try several interest rate (rate of return) calculations and savings amounts to find out how long it will take for your money to grow.

Spend consciously.

Have you ever thought about the trade off between spending or saving and what it actually costs? Are you more of a saver or a spender?

A version of this article was previously published (comments remain).

    10 Comments

  1. Calculating the net present value of a future cashflow is a useful way to determine the time value of money. To calculate:

    Amount / [(1+Opportunity Cost Rate of Return)^Number of Years]

    For example, the net present value of $100 in 3 years time when the alternative is to put the money into a 5% term deposit would be calculated as follows:

    $100 / (1.05^3) = $86.38

    This means that if you had the choice between receiving $90 today or $100 in 3 years time, you’d be better off choosing the $90 as the opportunity to invest it in the 5% term deposit is worth more than the $100 down the track.

    Financial Independence

    September 2, 2013

    • @Reach-Thanks so much for adding to the conversation and elaborating on the concept. The only real difficulty is if the discount (interest) rate is uncertain. That makes the NPV calculation more difficult.

      Barbara Friedberg

      September 2, 2013

  2. Always a saver! I am a little concerned about changing when I retire. I will need to transition as I get closer to the date.

    krantcents

    September 2, 2013

    • @Krantc-I feel fortunate as well that I’ve been a saver. I think it makes ones financial life much easier!

      Barbara Friedberg

      September 2, 2013

  3. The concept of time value of money, specifically the math behind it, is one of the more practical things I learned in school. It was early in grad school, and I’ve used that all the time. Very useful for decisions on financial planning, as well as purchasing decisions and opportunity cost.

    Squirrelers

    September 2, 2013

    • @Squirrelers, I use this concept weekly in decision making. It should be taught in high school!

      Barbara Friedberg

      September 2, 2013

  4. Hi Barbara, I agree with you and Squirrelers. Time value of money is a very good way to make planning decisions. Great post with easy to follow examples.

    Bryce @ Save and Conquer

    September 3, 2013

    • @Bryce, Easy to follow examples is exactly what I’m going for. I really appreciate the feedback! This is one of the finance concepts I use the most.

      Barbara Friedberg

      September 4, 2013

  5. Would like your take on simple investment method Theirs tons of ETF’s out their why not focus on narrow sector funds single country funds that are down at least 75% from highs than double your position every time the fund declines another 5% Example I will use Junior silver ETF as EXAMPLE Fund currently down buy 75% from high start 500 dollar position double position at 80% 1000 double again at 85% 2000 double again at 90% 4000 and if it were to drop 95 double again 8000 build diverse list of funds over time place stop 15% below current price stop loss order at which time fund has recovered 75 percent of decline from high say fund was at 100 now its at 75 up from just 20 few years back. Stop loss at 75 to execute if stock reaches 62.75 The way I see it this method puts you in funds that are trading at bargains prices while limiting your risk while maximizing your return. Most likely A large amount of money would remain in cash its only on rare ocassions when their will be great bargains to be had. Best part is the stop loss order you do not have to worry about a stock closing at 20 opening at 14 biggest difference between open and close for a ETF would most likely be 10% Put this method to the test i am sure it is most likely the simplest but most effective investing method of modern times.

    This is for non leveraged ETF’s only One other thing how in the world can the SEC alow ETF companies to market leveraged ETF’S as ETF’s their derivatives.

    Jim

    December 27, 2014

    • Hi Jim, There are a couple of issues I see with your strategy. I’ll start with the cons and end with the pros.
      First off, I prefer to use a simpler, research proven overall investing plan, i.e. index fund investing in line with one’s risk tolerance and rebalancing annually. The basics are laid out here http://barbarafriedbergpersonalfinance.com/best-investing-wealth-tips. I don’t know if there is any research backing your approach.
      Additionally, just because a sector is down doesn’t mean it’s going up again any time soon. Gold was down for decades before rebounding. Additionally there are countries which also experience long term downturns.

      On the positive side, I suppose if you are invested broadly enough using this strategy it might be possible to beat a traditional index fund strategy. Contrarian strategies occasionally outperform.

      Do you have an long term (greater than 10 year) statistics on the returns of your approach versus simply investing in a few national, and international index funds?

      Let me know how you’ve fared and we look forward to your response.

      Barbara Friedberg

      December 28, 2014

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