Hopeton Morrison, Gleaner Writer
Of all of the concepts employed by financial analysts and planners, none is more important than the 'time value of money'.
It is a concept that is applicable to large organisations as well as small investors and is also referred to as 'discounted cash flow analysis'.
A dollar in your hand today is worth more than a dollar to be received next year this time.
The argument is straightforward. You can invest that dollar for one month right now and earn interest on it. You can also engage in this investment cycle for an entire year or more, each time reinvesting your principal and interest, thus engaging in the process of compounding.
Stated another way, compounding is the process of going from today's money value or present value (PV) to a value in the future, appropriately termed future value (FV).
So, how does this affect your own investment decisions? Let us say that you invest $100,000 in a long-term savings account (LSA), which offers tax free benefits over a five- year period.
This investment is offering 10 per cent interest per annum. At the end of five years your gross returns will be $161,051 representing total interest over the five years of 61 per cent. Because you have compounded, your five-year returns actually work out at average annual real return of 12.21 per cent (that is, $161,051 divided by five), significantly more than the nominal 10 per cent you invested at initially.
From this example, we see that an initial amount of $100,000 invested at 10 per cent per year over five years would be worth $161,000 at the end of the
period.
That initial investment of $100,000 is the PV of $161,000 due in five years.
Now, what if you could buy an instrument today that would be worth $161,000 in five years but for which the price is less than $100,000 now?
Prudence dictates that you should buy it. What then if you could price all of your future investments in this way? It is a common procedure in finance and is the opposite of compounding, termed 'discounting'. Simply stated, if you know a PV you can compound to estimate the FV, while if you know an FV, you can similarly discount to find the PV.
Compounding and discounting
Although these procedures are commonly performed by personal financial planners and finance directors in large organisations, it is an exercise that you can master yourself.
Compounding and discounting are two sides of the same coin and are based on four variables: present value (PV); future value (FV); interest (i); and time (n). If you know the value of any three of these, you can find the value of the fourth.
Let's say you bought a security at a price of $100,000 and are guaranteed a payment of $182,000 after five years. Without taking you too much into the mathematics of it, the simple equation is: FVn = PV (1 + i ) to the nth power.
The formula is broken down as follows: $180,000 = $100,000 (1 + i ) to the fifth power. This works out to be 12 per cent.
Suppose on the other hand you invest $100,000 at an interest rate of say 12 per cent, and your goal is to save $1,000,000? You want to know how long it will take to save that amount. You refer to the same formula: FVn = PV (1 + i) to the nth power and break down as follows: $1,000,000 = $100,000 (1+0.12) to the nth power and solve for n.
It would take you 20.32 years to achieve your goal of $100,000 if you allow your investment to compound at 12 per cent annually.
Truthfully, you will ideally need a financial calculator to master these calculations.
Hopeton Morrison is general manager of
St. Thomas Cooperative Credit Union Limited and lecturer in the School of Business Administration at the University of Technology. Email: hmorrison@stccu.com.
