The value of a dollar in a pocket right now is worth more than the same dollar in the same pocket a year from now. This is because of inflation; as time passes, prices go up. Because of this, it’s important to think about the time value of money when making decisions that have cash flow spanning multiple periods.
To find the present value of a single amount from the future, divide the lump sum by a present value factor. This present value factor is the interest rate plus 1 raised to the number of periods. Let’s say your client needs $20,000 for a down payment in two years and expects to earn 5% during this time. The numerator is $20,000. The denominator is (1 + .05)^2. By dividing $20,000 by 1.1025, you calculate the present value to be $18,140.59.
From the example above, it’s easy to see how the future value of a lump sum is calculated. If you want to consider the time value of money for something today, multiply (instead of divide) the lump sum and the present value factor. Multiplying $18,140.59 by 1.1025 gives you $20,000. In other words, if your client invests just over $18,000 and earns 5% over two years, it’ll have what it needs for its down payment.
These examples show how important it is to factor in time. For the above project, your client doesn’t need $20,000 today. It needs just over $18,000, which frees up $2,000 to be spent on other projects that can help grow its business. The concept of the time value of money can be tied into other analysis tools like payback period or internal rate of return.
Accountants typically don’t need to care about the time value of money for most of their transactions. If you use the cash basis of accounting, you’ll never record time value of money in your books. The time value of money concept is a great tool when trying to help clients choose between projects when the timing of cash flows isn’t consistent. Take what you know, calculate the impact of the interest rate and time period, and use this information to make the best business decision for you or your clients.
