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Time Value of Money: Present & Future

Running a business may be a little complicated at times but there are some relatively simple concepts that provide the tools for more effective decision making. One of those is understanding the Time Value of Money.

Time Value of Money

If you were offered a payment of $10,000 today or $10,000 in three years you would nearly certainly take possession of that money today. But would you understand the dollar difference between those two amounts? Would you be able to calculate the Future Value return of that $10,000 invested at 5 per cent over the three years?

Similarly, if you were offered a contract that paid $800,000 in three years on completion of a project you would need to know the Present Value. You may have also been offered another contract that promised $640,000 in two years. Being able to do these simple calculations will enable you to make an informed decision about which project offers the higher return in today’s money.

I generally use a financial calculator but you can also hunt out financial tables that slightly alter the equations. Or, even more effectively, you could jump into a spreadsheet and use its functions to solve the calculations.

Calculate the Future Value of Money

The simple formula for calculating the Future Value of an amount of money is:

Future Value = Present Value * (1 + i)n

Present Value is the amount of money in today’s value; i is the interest rate for the period (whether month, quarter or yearly), and; n is the number of periods.

So if the interest rate was five per cent per year compounding over two years you would plug those numbers into the equation. Similarly, if the interest rate was two percent per quarter over two years then you would plug in i as two percent but n would become eight (because there are eight quarters in two years).

The n is the number of periods that the interest rate compounds. Don’t be confused that this is always years… it could be any given increment of compounding interest.

Example of the Future Value of Today’s Money

If you wanted to compare that $10,000 example between today and three years time at an expected interest rate of five per cent you would solve the following:

  • Future Value = $10,000 * (1 + 0.05)3
  • Future Value = $10,000 * 1.1576
  • Future Value = $11,576.25

This means that your real choice is to take $10,000 today or $10,000 in three years time… but if you took it today and invested $10,000 at five per cent interest over that three years you would have $11,576 in your account. The choice is simple and while you knew it instinctively it helps in business to calculate a definite figure.

Solving for the Present Value of Tomorrow’s Money

The next calculation is similar. if you wanted to know what that $10,000 in three years would be worth in today’s money, given the same interest rate, you would solve the following:

Present Value = Future Value * (1 + i)-n

This calculation depreciates the Future Value by the interest rate over the number of terms. Plugging in our $10,000 values it becomes:

  • Present Value = $10,000 * (1 + 0.05)-3
  • Present Value = $10,000 * 0.8638
  • Present Value = $8,638.38

So, when you consider that $10,000 offer to be handed over in three years time you can quantify that as only having a Present Value of $8,638 to your business in today’s money.

A Handy Alternative to find Present Value

If you skim back to the Future Value calculation you can invert the equation on the second step to figure out what that $10,000 in three years time would be worth to you as a Present Value:

  • Future Value = $10,000 * (1 + 0.05)3
  • Future Value = $10,000 * 1.1576
  • Solving for the Present Value of a $10,000 Future Value instead:
  • Present Value = $10,000 / 1.1576
  • Present Value = $8638.56

So if you have that first equation solved it’s just as easy to invert the formula and solve for the Present Value.

Summing up the Concept

The Time Value of Money concept is simple enough – that a dollar today is worth more to your business than the same dollar in three years time. Partly because you can utilise that dollar over those three years to your benefit. Partly because money devalues over time and you can buy less with $10,000 in three years than you can buy today.

This should also lead you to a simple business insight about your company cash flow because it has everything to do with the understanding of the Time Value of Money. You should collect money as early as possible without straining relationships and pay out money at the latest possible time just before the invoice dictates.

If you collect sooner then money will pool into your finances and be available to collect interest or benefit from other investment. If you pay later then your financial accounts are similarly bolstered by a pooling of unpaid money.

There is no direct financial gain to your business, all things being equal, in paying early and receiving later.

Do the figures and you’ll see that your business finances can be significantly more profitable by following that maxim. I’ve seen small trades businesses pounding under the weight of $100,000 finance when I can see that this simple maxim would pay out that debt and more. It’s worth taking on board.

Time Value of Money 101 Series

  1. Time Value of Money: Present & Future
  2. Time Value of Money: Financial Tables
  3. Time Value of Money: Ordinary Annuities
  4. Time Value of Money: Annuities Due
  5. Time Value of Money: Mixed Streams
  6. Time Value of Money: Compound Interest (redux)
  7. Time Value of Money: Nominal versus Effective Interest Rates
  8. Time Value of Money: Accumulation of a Target Sum & Loan Amortisation
  9. Time Value of Money: Time Periods to Reach a Sum & Growth Rates

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About the Author

Steven Clark Steven Clark - the stand up guy on this site

My name is Steven Clark and I live in the Derwent Valley in Southern Tasmania. I have an MBA (Specialisation) and a Bachelor of Computing from the University of Tasmania. I'm a mazer & a yeast farmer (making beer, fruit wine and mead as by-products of continuous improvement in my farming practices). I'm a photographer, although my film cameras are currently silent. I do not tolerate idiots. I do not tolerate bigotry. I do not tolerate excuses. Let's be clear, if you sit with my enemies you my are my enemy for life.

Blogger. Thinker. Brewer. Drinker. Life partner to the amazing and incredible Megan.

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