How Does the Time Value of Money Affect Businesses?
Just about everyone who saves and spends money is affected by the so-called time value of money -- the idea that $1 today has a different value, usually more, than $1 at some point in the future. Businesses have to be especially aware of the time value of money, as it plays a large role in determining whether a project is profitable.
For a business, the key factor in calculations involving the time value of money is the discount rate. That's the rate you use to "translate" today's dollars into future dollars, or vice versa. For example, say your business has the option of getting paid $1,000 today for a year's worth of services, or $1,000 a year from now. If you get the money today, you can reinvest it in your operations. If your company's typical annual return on investment were 3 percent, you could taking the $1,000 today and turn it into $1,030 a year from now. So at a discount rate of 3 percent, $1,000 in today's dollars is worth $1,030 in year-from-now dollars. Meanwhile, $1,000 in year-from-now dollars is worth just $970.87 in today's dollars.
The time value of money is central to many capital budgeting decisions -- that is, the choices a business makes on which projects to pursue to make the company grow. Examples include expansions, investments in new equipment or developing new products. Capital projects typically involve significant upfront investment, with positive cash flow coming in only after the project is up and running. A project is worth pursuing only if the cash flows that you estimate will be generated by the project will make up for its cost. Since those cash flows will arrive in the future, you must convert them to today's dollars -- "present value" -- to compare them to the cost.
Say you're thinking of opening a new location, which will cost $100,000, and you estimate that it will generate $15,000 a year in net cash flow for 10 years, for a total of $150,000. On the face of it, the project looks like a moneymaker, but that's before taking into account time value. Now say you'd borrow the money for the project at 6 percent annual interest, with the loan repayable over 10 years. To be worthwhile, the project must not only pay back its upfront cost but also cover the interest on the loan. So you'd use 6 percent as your discount rate. At that discount rate, the combined present value of those cash flows is about $110,400. Subtract the upfront cost, and the project itself has a "net present value" of $10,400. It's still profitable, so it's worth doing. However, if the estimated cash flows were only $13,500 a year, then the present value of the future cash flows would be only about $99,360 -- you'd lose money on the project.
Time value also matters to companies negotiating contracts for payment. If the contract is for a year's worth of work, getting full payment right now is more valuable than getting, say, one-third upfront, one-third in six months and one-third upon completion. Even that is better than waiting a year for the full payment. The farther a payment is into the future and the higher the discount rate, the less that payment is worth in today's dollars. Companies that sell subscription services -- pest control, for example, or lawn care -- commonly give discounts for customers who pay in advance, and the farther ahead they pay, the deeper the discount. These companies are capturing the time value of money and refunding a little of it to the customer.