MBA Class; Time Value of Money in Financial Decision Making
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.
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.
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.
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).