Time Value of Money
| | Monday, August 29, 2005 @ 10:25 AM EDT
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Contributed by: James Kobzeff
James Kobzeff Properties
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Time value of money is the concept of measuring the value of money over time.
After all, not unlike all things in life (unfortunately), the value of money does to change with time. What’s more, because it’s crucial to analysis of a real estate investment, being able to measure and solve for those changes is paramount.
So, let’s consider its key components.
Present Value
Present value defines what a dollar is worth today.
For example, take a four-pack of bottled iced tea that costs $4.00. Because one dollar has the purchasing power to buy one bottle, it can be said that the present value of a dollar equals one bottle of iced tea.
Future Value
Future value defines the worth of a dollar at some future time (let’s say, one year from today).
Go back to our example and assume an annual inflation rate of 5%. One year from today, one bottle of iced tea will cost $1.05. That would make the future value of a dollar worth 95% of a bottle.
Now, compare the present and future values of the dollar. What do you see? Hopefully, that its purchasing power has declined, and that it won’t buy as much in one year as it does today.
Good. That’s the idea behind the concept. Having $1.00 today is preferable to having that same amount in the future. And in turn the reason why investments need to be studied from a time value of money standpoint. Because the timing of receipts might be more important than the amount received.
To solve for this relationship between present and future value, two mathematical procedures known as discounting and compounding are applied. Let’s look.
Discounting
Discounting is the mathematical procedure for determining present value.
Consider the iced tea example under Future Value. We know the future value ($1.05) and want to solve for present value. So we discount $1.05 at a rate of 5% for one year and determine $1.00.
Compounding
Compounding is the mathematical procedure for determining future value.
Consider the example again. We know the present value ($1.00) and want to solve for future value. So we compound $1.00 at a rate of 5% for one year and determine $1.05.
Okay, that’s the technical stuff. Let’s consider some examples that apply the procedures and should help drive the point home.
Assume Investor1 has two options with the sale of a property. Take it all now, or receive a greater amount in x number of years. The average annual inflation rate is assumed to be x percent. How would Investor1 know which is the better option? Solution: Solve for present value by discounting the future amount at the rate and years then compare it with the amount that can be taken now.
Suppose Investor2 plans to invest x amount of money yielding x percent for x number of years. How much should Investor2 expect at payoff? Solution: Solve for future value by compounding the present value at the rate and years.
Right. This is not easy stuff. But understanding the concepts and being able to solve and manipulate these procedures might be the difference between gaining or losing some hard earned dollars.
Note: James R. Kobzeff is a licensed Broker and apartment specialist in Salem, Oregon. James is also the developer of ProAPOD™ Multifamily Marketing & Analysis Software and ProAPOD™ TVM Calculator
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