The person who doesn’t know where his next dollar is coming from usually doesn’t know where his last dollar went –Unknown

Time is more valuable than money. You can get more money, but you cannot get more time.” — Jim Rohn

AND THE WINNER IS!! … (drum roll… then suspense)… Carole Ramsay! Carole jumps, screams and hugs her friends, then screams again, then realised she was now hugging a stranger — she was so excited! After all, she just won the $20-million prize that the retail outlet was giving to one lucky winner for their Christmas Bonanza! And to think that she nearly went to the competitor across the road when she wanted to buy her new fridge for the holiday!

Wow! After posing for the cameras — grinning like the child who got loose in the candy store — she is now sitting and waiting in the manager’s office who had sweetly asked Carole to meet with her to be reminded of the “terms of the payment”. She could hardly contain herself, and in her mind was busy spending the $20 million on the house and the car she always wanted. Despite inflation she knows that she could still buy an apartment and a decent new car — cash! And still have even $1 million or so to save. She could pay off her credit card bills… and, “I could then be debt free!” She smiled at the thought.

The manager, Mrs Pink, breezed in, and had to repeat her excited congratulations to get Carole back to terra firma. She repeated, “Congratulations, Miss Ramsay, on winning our $20 million prize. I hope you have some good plans for the money!”

“As you know,” continued Mrs Pink, “the terms of the payment were outlined on the competition entry form that you filled out. The payment will be in the form of a $1-million payment once per year for the next 20 years… please complete this form so we will know where to send the money.”

“Awww …..yu …you…are you saying th..th..that I will not be getting the whole $20 million now?” Carole sputtered.

Time value of money

You don’t need any special finance training to know that money received now is worth much more than money received later. If I were to ask you whether you prefer $1,000 now or $1,000 next month, you would choose to get it now (remember, we are only talking about rational people here!) Intuitively, people know that “time is money”.

The time value of money is the simple concept that it would be much better for me to get $1,000 today than $1,000 next year this time. Today I might be able to buy lunch with the $1,000, but I may not be able to use the $1,000 to buy the same lunch next year.

Looking at it from another perspective, suppose you were promised $1,000 in one year’s time — what would it be worth now? If you can figure it out, that would be the present value of the $1,000 — and this amount would definitely be less than the $1,000. The present value is what Carole needs to calculate to see the real value of that $20 million today. We will work that out later.

Future value

The related concept to present value is the future value of money, and is simply the value of $1,000 at a future time after having invested it (so that it earns interest) for that period of time. So if the interest rate is 5.0 per cent after one year the future value of the $1,000 is $1,050. You would (or should) know that the interest rate paid on money borrowed is really the price that is paid for the service of using other people’s money (Michael Lee Chin loves to talk about OPM — and shrewd investors usually know how to leverage OPM!)

Over the 20-year period, let us assume that money on average could have been invested at say 5.0 per cent. It would be easy to calculate what the 20 $1 million annual payments to Carole would be worth today using the Present Value function in MS Excel. Remember that all those $1-million payments in the future will not be worth the same.

Excel PV function

We had touched on Excel before, and realised that there are several amazing features. In this case, Excel can help us to get an idea of the value today (the present value) of those 20 annual payments in the future. The function requires an input for the estimated annual interest rate over the period — we will use 5.0 per cent; the number of periods — we will use 20; and the payment per period — that value is $1,000,000. To input this in Excel enter the following in a cell (without the quotes), “=PV(5%, 20, 1000000)” then press enter.

The result shows that the money that Carole is going to get is really worth a little over $12.4 million in “today” money. In addition to that, do you know why many Jamaicans enter the popular “partner” scheme? Even though they actually get less than they actually save? Because they get the money in one lump sum — and they can “see” their money, but if they get the money in small bits they would say the money “mash up” and then it is not of much use to them.

To make matters worse, money in the future is riskier. You may not know what the inflation and interest rates will be during the ensuing periods. Suppose the average interest rate over the 20 years became 10 per cent, then the present value of the payment would drop further to about $8.5 million (you can try it by changing the 5.0 to 10 per cent in the Excel example). Additionally, if our generous retail store were to go out of business after two years (having only paid one or two payments), Carole may very well forfeit the rest of her winnings! Ouch!

Dr Kenroy Wedderburn is an MBA part-time lecturer. Send your e-mails to drkwedderburn@gmail.

com.