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Time Value of Money

If I offered you a $100 bill, would you take it?

What if I offered you your choice of a $100 bill today or the same $100 bill three years from now?

What if I offered you your choice of a $100 bill today or $200 three years from now?

Somewhere around there is your understanding of the time value of money, the extra amount you demand if you're going to have to wait to get money. Why do you demand a premium?

Our usual way of comparing one stream of payments with another is to discount both streams of payments back to their "net present value," using a discount rate that everybody agrees is fair. If we use a discount rate of 6% (which is a typical a discount rate used by financial professionals), for example, we can compare three streams of payments that look completely different:

Now about that discount rate. A 6% discount rate may be appropriate when the collection risk is negligible, that is, when there's little or no chance that the person required to pay would fail to follow through. Rarely would it be appropriate, however, to use such a low discount rate when the designated payer is an individual (which is usually the case in divorce). In those situations, it might make more sense to use 12%, or even 20-25%. So how would those values look then?

If you study those numbers carefully, a couple of truths should bubble up:

1.  There's nothing like the safety and security of getting that money today. Not 10 years out, not two years out, not tomorrow; today, please.

2. How much of a premium you require for waiting to receive money has a lot to do with how much risk you think you're taking on by waiting. Or to put it another way, how seriously has this person taken his or her financial obligations in the past, and do you have reason that's going to be better or worse in the future?

This one doesn't come from the numbers but is an accepted axiom of financial risk: the longer you must wait to get your money, the greater risk you're assuming (and the higher the discount rate you should use).

To take another issue, if you're negotiating with your spouse about an extra $50 per month of alimony for the next five years, first you need to reduce that payment to account for the tax treatment. Let's say the after-tax cost or benefit to you is $38 per month. Discounted, say at 10%, that stream of payments is worth $1,788 to you today. Armed with that information, you can think strategically and decide whether it's worth it to keep fighting about it. Or perhaps you should trade another issue for it. Remember, mooshing is permitted.

If you're looking for just the right calculator to help you figure the present value of money, start with the great assortment of calculators offered at Time Value Software.