I’ve always wondered how I would react to winning a million dollars in the lottery. Taxes aside, if given a choice to take payments over 30 years or take a lump sum now, which would be better? Taxes aside, it is better to have the million in hand now rather than wait to collect it over time. I think I could probably grow the million to a great deal more if I had it all to invest right now.
But the reality is that many factors influence decisions like this, and they take careful consideration of the Time-Value-of-Money (TVM), discounts, and risks. Like any good business decision or risk, we need information to make good decisions about how and when to use our business cash.
What is Time-Value-of-Money?
TVM is the simple premise that, due to interest, invested money increases in value over time. A bird in the hand is worth two in the bush, especially if you can invest that bird to earn more for you. But money also has future potential like the birds in the bush. If you have money to invest now, it can be more valuable later if you make the right decisions.
The easy-to-grasp idea is that an investment will grow over time. For example, if you deposit $1,000 into a savings account that pays interest of 5% annually, your value in one year will be $1,050. If the payout of interest is more frequent, say quarterly, then the value compounds and grows more quickly. That same present value (PV) amount of $1,000 will be worth $1012.50 after only three months based on one-fourth of 5% (1.25%) interest quarterly, and the extra $12.50 is added to the amount that is earning interest. By the end of the year, the FV is $1050.95, and an improvement of $0.45. Daily compounding, if available to you, exponentially improves the result.
That’s a simple schoolbook example, but calculating financial decisions in your business is the tricky part. You probably are not putting money in a savings account; instead, you are putting it to work in the business and trying to decide the priorities that will provide the greatest return possible. That includes decisions ranging from buying assets (either buying them at all or deciding between paying cash and financing over time) to launching products to opening new offices. Each decision has a financial (TVM) component to it. Competing decisions that a business must make rely on the need to consider the Time Value of Money.
When Does It Matter?
The Time-Value-of-Money is important in capital budgeting decisions because it allows business owners to adjust cash flows, thereby impacting its total cost (both in today’s and tomorrow’s financial values). It fluences every financial decision an organization makes, and its value is not relegated only to the CFO. It influences decision-making about every expense—in accounts receivable, purchasing, and HR departments, too. You often have to do some tricky calculations. but it affects every-day decisions like these:
- Extending Credit to Customers: Sometimes, we offer credit terms for our products and services to worthy customers. We do this to increase their buying options to make a sale, but we might offer a discount for paying quickly. We do this to reduce our risk and to refill the coffers as quickly as possible. However, we might find that we make more money on extending credit and prefer to make financing an integral part of how customers buy our products or service. It also impacts how we price those goods and services (as financing options can increase demand, which pushes up price).
- Buying on Credit from Suppliers: If we determine that the calculated value of paying over time is better for the company, it is sometimes wise to do so after considering cash flow needs, terms, or other company plans. Keep in mind that what works for some organizations will not work for others. If you can negotiate a cash purchase, for example, for new machinery that is discounted enough to make it worthwhile over the life expectancy of the machinery, you would—IF you have the cash. But, many SMB’s must keep their cash liquid for other operating needs and then instead negotiate the best possible credit and loan terms to buy materials and supplies.
- Buying Capital Assets (Cash vs. Leasing): Because the acquisition of capital equipment can often increase a company’s cash flows (the new equipment might increase speed to market, or may increase production capabilities), the decision to pay less today (cash) or more over time (lease) must include the consideration of the timing of the inflows and outflows that the capital asset requires and creates. Is a down payment required? How long until the purchase impacts sales? The answers guide the proper decision.
- Comparing Options: Businesses often have to choose from among competing opportunities, rather than accept every one that presents itself. Here, TVM is used to understand all costs properly. The total cost approach permits small-business owners to evaluate multiple projects at one time. In this method, the manager adjusts all cash inflows and outflows for each competing alternative and then compares them. All projects with positive net present values are acceptable; however, the project with the greatest net present value is the most profitable.
- Hiring a Salesperson or Other Influencer: A new high-power salesperson might be a boon for your company revenue, but it takes time to close deals. If they don’t start earning their own wage in profits until year #2 of employment, how can an organization sustain the increased payroll? To understand TVM, you would need to know all of the costs (bonus, commissions, wages) and all of the benefits (estimated incremental sales amounts and timings) to best determine the hiring and compensation decisions.
- Standard Investment Decisions: Well-funded businesses must properly manage those deep coffers—this is performed by the Treasury group, and their responsibilities are to deploy and position a business’s assets properly. Each of their decisions is based on TVM and the maximization of profitability. That is what a for-profit business should do.
Businesses make economic decisions every day. A for-profit business is expected to have financial considerations in its decision making, expressly because their goal is profit maximization. While sounding simple, this approach has its challenges. For one, changes in inflation and interest rates are not considered—those can significantly impact today’s forecast of tomorrow’s performance. Additionally, the forecast cash flows are exactly that—a forecast. We all have experienced the relative accuracy (or not) of one’s forecast. Finally, all those factors that go into a business’ risk rate (it’s expected rate of return for similar decisions) can change as the business changes. Finally, this is a dynamic world, with tumultuous market forces, and by its very definition, market risk is not forecastable.
Yes, it is a gamble to make decisions based on future assumptions. That is exactly what risk is and why some decide to take the up-front lottery payout, and others receive the benefit over time. How something is going to perform in the future and what that is worth in today’s terms are at the heart of business decisions. Using simple concepts like TVM and the present value of money should help provide the insight needed to optimize your decision.
time value of money – DepositPhotos