The Time Value of Money

Here is a paper I wrote for a finance class I thought was a clever way to explain the Time Value of Money.

As most loan sharks know, the interest is what generates the profit. While not condoning illegal behavior, the more seemly side of finance does illustrate a valid point: when people need money, someone has to be willing to lend it to them. But, this is not without its risks. Loan sharks typically charge a high interest rate – “the vig” – compared to other institutions. This is because they assume more risk of non-payment. Additionally, their collection policies are somewhat different than the corner bank. While perhaps an extreme example, this arrangement presents the same challenges as any other use of money. The shark must consider not only the potential of being repaid the principal of the loan – “the juice” – but the opportunity cost of the loaning the money to the customer. Opportunity cost is defined as "the advantage forgone as the result of the acceptance of an alternative” (About 2006). In this case, the loan shark could otherwise invest his money in gambling, racketeering, carting or some other activity. The future value of those enterprises with the same money must be weighed against the interest paid on the juice. If the loan shark loans $10,000 for 7 days in return for a total payment of $12,000, then the $2000 interest payment must be higher than the potential opportunities the $10,000 could have been used for in the interim 7 days. Depending upon the depth of the shark’s organization, $10,000 may indeed be able to generate more than $2000 in a 7 day period. This would be an example of the opportunity cost being more than the realized profit from the enterprise.

To bring this discussion into the realm of the legal, the same applies for countless examples in personal and corporate finance. In both of these areas, money must not only be considered as a current commodity, but for the investment vehicle it provides. Specifically, any potential investment must not only be considered in terms of the return but the potential of that money to perform in other ways. For example, while dipping into Retained Earnings to finance a new plant might be a way for a company to minimize debt, the potential advantages of liquidity must be outweighed by the incurrence of the debt. Many times, a corporation with cash-on-hand will still assume long-term debt since the retained earnings may be able to return more as an investment than the interest on the debt. While it would seem to be in the company’s best interest to carry as little debt as possible, it may actually cost money to not borrow money if borrowing cash means better earnings on other investments.


Another area that corporations (and loan sharks) must carefully analyze is the effects of recurring payments on money over time. For example, the protection money that the local deli pays to the Stunad crew is an example of an annuity as the money is paid in a fixed amount over time. The annuity would typically end with the untimely demise of the Stunad captain or the deli owner – whichever comes first. In paying this annuity, the deli owner must consider the opportunity cost of paying the money versus investing in his own business. However, as with all opportunities, the owner must also consider the ramifications of forgoing the investment in his personal welfare (specifically the aforementioned untimely demise). In the Stunad crew’s case, they must consider the cost of administering the annuity with items such as collection fees, opportunity costs of enforcement versus other enterprises and the value their other enterprises would reap in a long-term investment. Typically, this protection annuity is deemed to be in perpetuity as the organization would continue to collect even if the owner changed hands. Just as with the Stunad organization, large corporations must consider the long-term effects of annuity vehicles such as pension plans. Pensions must be funded from funds inherent within the pension or from net income. In a public company, this presents a charge against earnings each year that only continues as workers get older and continue to retire. The annuity in this case can present an undue burden upon the operations of the company and prevent future investment or expansion.


While it would seem that typical Mother’s and Father’s Italian Associations and large publicly-help corporation may be very different; within their business dealings they must consider some of the same issues. The ability to generate cash is but one factor in the successful operation of their business. They must also consider the cost of their investments and the cost of taking -- or leaving -- an opportunity. With proper attention to the time value of money, the whole family prospers.


References
About.Com (2006). Opportunity Cost – Every collar we spend is actually 6.7 lost forever. Retrieved April 6, 2006 from http://credit.about.com/cs/consumerwisdom/a/081100.htm.