G.H. Condit, Inc.

Time Value of Money

To go into debt, or not go into debt? That is the question. It’s one that I am often asked about. In some instances debt is a necessity. What you should remember about taking on a debt is that the time value of money takes effect. Huh?

The important thing to remember about business is that no matter how you spend money as a business owner you have to think of it in terms of an investment. If you are spending money on property and equipment, or on hiring an employee, you should be asking a simple question. How much money will I receive in return for my investment?

Which would you rather have? $100 today or $100 tomorrow? It seems a strange question, but many do not consider that $100 today is worth more because it can be invested today and start earning interest right away. Think in terms of a certificate of deposit. Say you buy a 1 year CD at 5% for $100. One year from now, you’ll receive $105.00. This means that one year from now $105.00, is worth $100 today. You can say that the future value of $100 is $100 X 1.05 = $105.00. In reverse, what we are saying is that the present value of $105 a year from now is $100.00, or $105/1.05 = $100.

$100.00 at 5% per year equals $105.00

or

Future value – $100 X 1.05 = $105.00

in reverse

Present Value – $105.00/1.05 = $100.00

This gives us what is called the discount factor which is the “1.05” in the present value calculation. It can also be written like this:

present value = future value X (1/(1 + r))

Back to the question of taking on debt as a business. Personally, I avoid it like the plague unless there’s no other choice. One important consideration is the interest rate you should use in the calculation. The rate you choose to plug in to the formula is what is known as your opportunity cost. It should be the best return you can get by putting the money to some other use. Basically you are saying that if I do “X” I’m giving up “Y”, “Y” being what you could do with the money that you are giving up to do “X”.

Lets say you don’t have a choice. You need a piece of equipment and you don’t have the cash. What you want to know is weather the present value of that piece of equipment is less than it’s future value. This is called it’s net present value.

To illustrate net present value let’s look at an example. Lets say in order to make and sell widgets you need a machine shop, and it will cost $500,000 to purchase and run in the first year. You have some cash, but you need for working capital so you take a loan for the full amount. If you had the money you could invest in the market and make 6%. You go to your sales team and marketing folks and some outside consultants to forecast sales for the first year. They say you’ll bring in $530,000 in year one. Here’s the formula.

NPV = – loan  amount + sales X discount rate

or in this case

NPV = -$500,000 + $530,000 X 1/(1+.06)

NPV = -$500,000 + $500,000

or

Zero

As you can see from this example you broke even in the first year. Not bad. It is important to recognize that you are making some assumption that may opr may not come to pass. What if sales aren’t as high or the opportunity cost is better than 6%. Here’s what that might look like:

NPV = Loan – projected sales X discount rate

or in this case

NPV = -$500,000 + $510,000 X 1/(1+.07)

NPV = -$500,000 + $476,636

or

NPV = -$23,364

Ouch, but….you’ve only figured for the first year sales. Throw in another year of sales like year one and you’ll break even with your very first sale in year two. What if you’re sales are projected to be much lower? Let’s say you ony project sales of $125,000 in each of the next 5 years and your discount rate is 6%. This changes the formula to account for the years following the first year.

NPV = – loan amount + sales/1.06 + sales/1.06² + sales/1.06³….

As you can see we’ve added an exponent to the discount rate, and this represents the year in which the we are calculating the present value of that year’s projected future sales. By far this is the best formula to use to figure the profitability of a long term project. From it you’ll discover how long it will take to break even, and the future profitability. Here’s what that looks like using out example:

NPV = – $500K + $125K/1.06 + $125K/1.06² + $125/1.06³ + $125K/1.06⁴ + $125K/1.06⁵

^or

NPV = -$500K + $117.9K + $111.2K + $105K + $99K + $93.4K

or

NPV = +$32.4K

(numbers rounded in the interest of space)

If you add the present value to your negative balance(the loan amount) for each year, one at a time you’ll see that the balance doesn’t turn positive on the loan until you get to about the last third of year 4.

The key to this whole exercise is to have forecasts that are as accuate as possible. You can project revenues out as far as you want. For each year you simply increase the exponent by one. As you go further into the future the probability of an accurate forecast becomes more and more difficult. You’ll have a ton of information to consider. New regulations and taxes, market conditions, industry trends, interest rates, and product life cycle are just a few of the factors that will contribute to how accurate your forecasts are.

Seems overwhelming, doesn’t it? Going into debt should not be taken lightly, but hopefully I’ve helped you to the answer the question: “To debt, or not to debt.”