TIME VALUE OF MONEY

Last week I talked about financial ratios and their application depending on who was using them. This week I want to cover the time value of money and how that can be useful in everyday decision making. The most common types of time money calculations that consumers use are auto loans and home mortgages.

When you go to buy an automobile one of the first questions they ask is how much you want your monthly payment to be. Before you buy a vehicle you need to decide what you can afford for a monthly payment, but more importantly you need to shop for the best rate and calculate the present value of those payments over the life of the loan. Then compare the present value to what you believe is a fair purchase price. Never buy a vehicle based just on the payment amount. That gives the dealership the flexibility to play with the price and financing.

The monthly payments over the length of the loan discounted at the interest rate on the loan equal the loan amount or present value. Another way of looking at it is if you were to put the loan amount in a savings account paying the same rate as your auto loan you would be able to make monthly withdrawals equal to your loan payment over the term of the loan. At the end of the term your savings account would have a zero balance.

The other type of present value is Net Present Value (NPV) which is the internal rate of return that a business would generate in order to discount a series of future (monthly, yearly) cash flows that would equal the cost of the investment. Suppose a printing business was fully utilizing all equipment, business was expanding, and needed to buy an additional printer to prevent a back log on orders. What do they need to know in order to make a wise investment? First, the company needs to know the cost of the printing equipment that is necessary to meet demand. Then they would need to know their estimated monthly gross margin which is revenue minus variable costs. Next calculate the interest cost to finance the equipment that you wouldn’t otherwise have to pay. Lastly, there is depreciation which is an expense, but not a cash outlay. If the corporate tax rate is 33%, depreciation only costs the company 67%. Most corporations have a targeted return or payback period that they require before they will make a capital investment. Therefore, if the equipment costs X and I were to invest the projected cash flows at the required rate of return how long would I have to receive those monthly cash flows before the discounted value equals the cost of the investment. If it takes eight years and the company requires a 5 year payback then they would not buy this piece of equipment.