THE TIME-VALUE OF MONEY

Time affects the value of money. It's the age-old adage that dollars today are worth more than dollars tomorrow. Grasping this important perspective goes a long way toward understanding the private paper marketplace. And it puts you in an excellent position to clarify certain financial decisions for your business.

To understand this concept, think of the flow of dollars in terms of the old bromide - "A bird in the hand, is worth two in the bush!" You know you won't go hungry. You also know that you won't have to spend any more time trying to catch your dinner!

What about those two birds in the bush? They present a whole series of decisions. For example, do you have to let go of the bird you have if you catch the two in the bush? Are there really two birds in the bush? Can you catch both? If you only catch one, will it be a better bird than the one you already have, and so on.

The point is simple: All investments involve a certain amount of risk. You are giving up money you already have, for an anticipated future that is greater. And, in deciding the worth of the expected additional benefit, you must evaluate risk of loss, depreciation, and opportunity cost.

Balancing these considerations is achieved through yield. The yield is your rate of return over a given period of time. Yield is used to judge use of a particular investment in itself, as well as in comparison to competing investment opportunities.

The Time-Value-of-Money

Intrinsic to yield calculations is time. Why is that? Well, lots of things can happen over time, and nobody knows with absolute certainty what it will bring. The longer you have to wait for your money, the greater the risk that you may not receive it or, at least, not all of it. Likewise, don't be deprived of the use of your money for the investment period and the collateral risk of lost opportunity with respect to alternatives.

The relationship between time, risk, and value is a natural consequence. Two basic mathematical formulas bear this assumption out. Fortunately, it works the same whether you are in Tranquility, New Jersey, or Bountiful, Utah. Even better, the formulas are plugged into simple financial calculators, which are easy to use, inexpensive, and available anywhere.

The first formula is where we take $1 and invest it at a set rate of interest over a period of years. We will know exactly how much the future will be at the end of that time.

The second formula is the reciprocal of the first. It tells us what a future value is worth when discounting the investment to its present value relating the time-factor, yields are calculated as an annualized percentage rate.

For example, we have a $10,000 note with a 10% annual interest rate, all due in one year. The first formula tells us the value of the note: $11,000 in one year's time, a yield of 10%. In two year's time, the value will be $12,100. In three year's time, the value will be $13,310.

Conversely, the second formula tells us that $11,000, due in one year, is worth $10,000 today, when discounted to yield 10%. So, what should we pay for $13,310 to be received in three years, discounted to earn 10% on our money? The second formula tells us $10,000 is the present value or purchase of $13,310 due in three years, discounted to yield 10%.

Yield is figured in one of two ways. First, compounding the future value as in example 1. Or second, discounting the present value as suggested in example 2. With either calculation, the value of money is directly related to the time when it is received.

Discounting

Here's a real-life scenario that demonstrates the importance of yield calculations.

Kerry Cash is looking at two competing, $25,000 private mortgage notes to purchase and wants to receive a 14% return on his money.

Anita Dough's note is payable monthly over 15 years, with a balloon due in ten years. Iwanna Hall's note is payable monthly over 20 years. Both are earning interest at 10% and both are comparably risk-rated. Each seller wants 82 cents on the dollar for the notes or $20,445. Kerry wants to earn his investment. Which note would yield Kerry his desired return, Anita's note or Iwanna's note?

The payments on Anita's note total only $44,882, while Iwanna's note equals $57,902. However, when discounting present value to yield Kerry's 14% rate of return, the stream of payments for Anita's note equals $20,445 (82 cents on the dollar), while the discounted present value of Iwanna's note to only $19,401 (78 cents on the dollar). How does this occur? Iwanna's note will not be paid off for 20 years, whereas Anita's note is paid in ten years. His is the power of time when it relates to money. Therefore, Kerry would purchase Anita's note.

Knowledge is power! You can use your understanding of the time-value-of-money to give added value to your clients and grow your business.