THE TIME VALUE OF MONEY

Every child understands the time value of money. Just ask a 6 year old if they would rather have an ice cream cone now, or tomorrow. The answer is obvious. Ask them whether they would like one ice cream cone now or two ice cream cones next year. Again the answer is obvious.

Let’s assume you have just won a cash prize of $10,000 in the lottery. Would you rather have your $10,000 now, or to receive it spread over the next 5 years at an amount of $2,000 a year. Nobody that I know would choose to receive the payment spread over five years rather than receiving the same amount of money now.

Let’s do some simple arithmetic. If you receive the $10,000 today its present value is $10,000 because you can spend it all today.  You will have the option of investing it at (say 5%). This means you will have $10,500 one year from now.

But if you will not receive the $10,000 until next year its present value today will be less by the amount of interest that could be earned during the year. The present value of $10,000 to be received in one year’s time is $9,523 because that is the amount that must be invested today (at 5%) to equate to $10,000 in one year’s time.

This simple calculation demonstrates the time value of money. The value of the money you have in your hand today does not have the same value as it will have in the future.

A $100 dollar bill you have today will look the same as a $100 dollar bill you may have a year from now. It may look the same, but if you have it today you can spend it today and enjoy the benefit of whatever you may buy with it today - not next year.

Its value may be eroded by inflation. It may only have 95 cents worth of purchasing power next year. And it may never be received because either you or the person who was going to give it to you may not live long enough for the payment to be made.

Do you remember the Popeye comic strip? Wimpy would say “I’ll pay you Tuesday for a hamburger today”. He understood the time value of money. He knew it was better to defer payment until next Tuesday for something he could eat today.

The value of a business can also be affected by the time value of money. The definition of Fair Market Value assumes a business will be sold for cash or cash equivalents. If the seller holds a note or a mortgage then some arithmetic must be done to calculate the present value of the transaction because some of the money will not be received until a future date. This fact is often overlooked or misunderstood by buyers, sellers and Brokers.

Let’s consider the sale of four businesses for a price of $100,000.

One is sold for $100,000 cash at closing. One with a 5 year payout, one with a 7 year payout, and one with a 10 year payout. Discount rates of 5% and 10% would yield the following present values.

                                                 Rate 5%             Rate 10%

Business # 1                         $100,000.     $100,000.           

Business # 2                       $  78,400.        $  62,100.

Business # 3                       $  71,100.         $  51,300.

Business # 4                       $  61,390          $  38,600.

This illustrates that the cash equivalents of the sales structures of these four businesses is quite different.