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When making financial decisions, do you consider the time value of money? If you have a basic understanding of time-value concepts, youâ€™ll be able to make better choices in many business and personal financial situations.
* Hereâ€™s an example. Say you want to sell a piece of property for $10,000 cash. A potential buyer offers $5,000 cash down, and $5,500 one year from now. How does the buyerâ€™s offer compare to your terms?
If you receive the entire $10,000 today, letâ€™s assume you could earn 5% on the money. A year from now youâ€™ll have $10,500, which is referred to as the “future value” of $10,000.
On the other hand, the future value of the buyerâ€™s offer turns out to be $10,750, which is the sum of the payment one year from now ($5,500) plus the future value of the down payment ($5,250). If the buyer has good credit, you may be better off taking the buyerâ€™s offer.
* Calculate present value. Another way to evaluate this kind of offer is to compare the “present value” of both alternatives. Using a financial calculator or special financial table, and still assuming you can earn 5% on your money, the present value of the buyerâ€™s offer is calculated to be $10,238, compared to a present value of $10,000 for a lump-sum cash payment. A higher present value means a better deal for you, so the buyerâ€™s offer is more attractive.
If youâ€™re on the other side of a transaction (buying something), time-value concepts can also help you make better decisions. For example, a time-value analysis can help you decide whether to buy or lease a car. You can also use time value to analyze investment alternatives, negotiate a divorce settlement, or hammer out the best possible deal when leasing real estate or business equipment.
If youâ€™re about to enter into any financial arrangement that requires you to pay money over time, or entitles you to receive periodic payments, time value could be an important issue.
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