Time Value of Money- Understanding how time relates with your money
Life is about decisions and choices, whether they relate to your work, business, or entire personal life. Often ignorance is the interplay between all these areas and the fact that a little interdisciplinary thinking can go a long way. This might not sound well, but many important decisions can be made more accessible by thinking just, and a bit differently.
Before we talked about value and utility, business is about creating value. Our personal lives for example according to economists are about maximizing our efficiency, where utility is merely a measure of the happiness or satisfaction gained from goods or services.
Think of it this way, and the business is considered first. If shareholders who may include either owners or investors could create more value themselves using other means, why bother running or investing in a business? Assuming we do not all have a continuous income stream, it comes back to this if you don’t create value in today’s economy, you will be forced to do one of two things. Change how you do things, or cease to exist. For business, the value question is rather important.
People have it a bit simpler in some aspects. Creating maximum utility is an incentive in and of itself. In the end, we all want more, whether it is revenue and growth for the business or old-fashioned service in our personal lives.
To get more, we go back to the decisions mentioned earlier, as all the choices we make have a direct impact on both value creation and utility maximization, in particular, those related to finance. Successful strategic management, e.g. the direction you want to take the business is supported by your investment policy which either undertakes choosing which projects to make and you’re financing system or how you fund everything. Linked to all of this is risk management, or how you handle the risks associated with these financial decisions.
Personally, financial decisions influence your quality of life, and your ability to enjoy the things you want. Once again we are back looking at the study of incentives – how people get what they want, or need, especially when other people want or need the same thing. In this case, it’s maximum utility.
One of the foundations of modern finance assists us in understanding which decisions to make, and it is equally applicable to business and personal finance. It is known as the time value of money. For instance, $1 today is worth more to you than $1 received in the future. Why? Money has a time value because of interest rates, no matter how measly, making $1 today more valuable than $1 received at some time in the future because it can be invested today to provide a return. The income from the investment will, in turn, make the dollar you get today worth more than the one promised you in the future. Perhaps an example best illustrates the point.
Again, this comes back to the incentives mentioned earlier. Interest rates are paid because someone else can use your money now, and they are prepared to pay you a return for the privilege of doing so, which is in truth a premium for taking the risk of giving your money to someone else. With business, this concept is part of what is known as the Sharpe-Linter Capital Asset Pricing Model, allowing people to work out, in today’s terms, the value of future cash flows on any project or decision requiring investment. The time value of money can apply to you, and specifically your utility. To understand how we need to look at things the other way around and get a handle on the incentives of everyone involved.
Think of Substantial personal assets
Think of substantial personal assets you might have, like a structured settlement or any property. The agreements reached in setting up the arrangement left you with a sense of security for the future and continuing, dependable payments over time. Comfortably, let us look at the incentives.
Think as they do. The illusion is that you will be better off down the track with the settlement. The problem is, they do not want you to have all your money now because they understand the time value of money. It is worth more to them, and they bank on the fact that you have not given it a second thought.
Remember that structured settlements are designed so that paying a business gets the maximum benefit from the time value of money. This does not happen by accident or through some amazing act of benevolence driven by concern about your long term well-being. It is a pure market and negotiating power. Considering the time value of your settlement, the incentive is for them to keep your money as long as possible to maximize their value growth.
Consider the time value of money
This discussion intends to make you think. Consider the time value of money in your personal life. How much value is there for you in holding first-mortgage on a property for twenty years, compared with maximizing your utility? How much efficiency is your monthly settlement check going to provide you in 10 years? Just think about increases in the cost of living over the next fifteen years, and how the monthly check stands up.
Avenues exist in today’s marketplace for you to better utilize these high-value assets like structured settlements and real estate notes. Naturally, decisions to do so should not be taken lightly, treating your most substantial assets as whimsically as an ATM card. Whether in business or your personal life, always consult a diverse range of industry professionals to increase the amount of information and knowledge brought to bear on any decision. As mentioned at the start, risk management is an essential part of any decision making process.
Remember the time value of money. It can be used both for and against you. And find out which way it is being used, look to which party has the more substantial incentives.
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