Understand the time value of money

Posted on May 1, 2012

When making financial decisions, do you consider the time value of money? If you have a basic understanding of time-value concepts, you’ll be able to make better choices in many business and personal financial situations.

* Here’s an example. Say you want to sell a piece of property for $10,000 cash. A potential buyer offers $5,000 cash down, and $5,500 one year from now. How does the buyer’s offer compare to your terms?

If you receive the entire $10,000 today, let’s assume you could earn 5% on the money. A year from now you’ll have $10,500, which is referred to as the “future value” of $10,000.

On the other hand, the future value of the buyer’s offer turns out to be $10,750, which is the sum of the payment one year from now ($5,500) plus the future value of the down payment ($5,250). If the buyer has good credit, you may be better off taking the buyer’s offer.

* Calculate present value. Another way to evaluate this kind of offer is to compare the “present value” of both alternatives. Using a financial calculator or special financial table, and still assuming you can earn 5% on your money, the present value of the buyer’s offer is calculated to be $10,238, compared to a present value of $10,000 for a lump-sum cash payment. A higher present value means a better deal for you, so the buyer’s offer is more attractive.

If you’re on the other side of a transaction (buying something), time-value concepts can also help you make better decisions. For example, a time-value analysis can help you decide whether to buy or lease a car. You can also use time value to analyze investment alternatives, negotiate a divorce settlement, or hammer out the best possible deal when leasing real estate or business equipment.

If you’re about to enter into any financial arrangement that requires you to pay money over time, or entitles you to receive periodic payments, time value could be an important issue. Before you sign on the dotted line, let us help you work through the numbers.