The Value of Money

10 March, 2015

Although undeniably the root of all evil, we all need to get our hands on enough money to keep us in those little luxuries that make life worth living – having a roof over our heads and eating regularly. However, spare a thought if you would for those trans-national corporations who have exploited their global presence in order not to pay tax anywhere. This means that massive war chests have been amassed over the years and corporate accountants are acquiring grey hairs in their efforts to maintain the value of these funds.

Project Managers, or at least those of you who have studied for the Project Management Professional (PMP)® exam, will be familiar with this problem. It is all about maintaining the Present Value of the funds. However, many of us are not aware of the Present Value phenomenon in our day-to-day transactions and enter into deals that seem satisfactory but are, in reality, not.

The Present Value concept can be summed up in one line: A dollar today is worth more than a dollar tomorrow. This is essentially because of inflation – inflation erodes the purchasing power of money. A typical example where the unwary get caught out by this is when a family member looks for financial help. Suppose your brother-in-law needs €5,000 now for some domestic crisis and promises to pay you back €1,000 every year over the next five years, is this a fair deal? On the surface it is: you do not want to make money out of the transaction, so giving €5,000 and getting back €5,000 sounds like you are simply getting your money back.

But let us look at what this means in terms of purchasing power. Assuming that inflation will run at 2% for the next five years then In terms of today’s value, the first €1,000 repayment is actually worth €980.39. It gets worse: the second repayment will be worth €961.17; the third will be €942.32; the fourth €923.85 and the final repayment €905.73. So, your brother-in-law’s fair deal will really cost you €286.54 if you think in terms of purchasing power.

Another factor we need to be aware of is opportunity cost. By giving €5,000 to your brother-in-law, you passed up on the opportunity to earn a reasonably good return from the bank, whose five-year deposit scheme offers 3% after tax. This would have transformed your €5,000 into €5,796.37. However, before getting too excited, remember that this figure will be in five years’ time, so in terms of today’s purchasing power, we need to determine what €5,796.37 becomes when you factor in five years’ worth of inflation. Assuming the same 2% as before, €5,796.37 five years from now is equivalent to €5,249.95 today. So by accepting your brother-in-law’s terms you are effectively foregoing the opportunity to increase your purchasing power by €536.49. Do not be surprised if your other, unmarried sisters get a lot of male attention once word of this transaction gets out – you are a soft touch!

For Project Managers, in charge of long-running projects, savings can be made by exploiting the present value concept. If pricing can be agreed in advance, it makes sense to delay purchases as long as possible in order to benefit from the reduction in Present Value. Project Sponsors are also concerned with Present Value. While an attractive set of returns might look good, calculate them in terms of Present Value and the effects of inflation make sobering reading.

This is why PMP® exam students have to learn the Present Value formula. This is effectively the same as the compound interest formula you learned in school.

Present Value = Future Value / (1 + inflation rate)number of years

Similarly,

Future Value = Present Value * (1 + inflation rate)number of years

It is easy to get these two equations confused. But remember the cardinal rule: a dollar today is worth more than a dollar tomorrow. Therefore fewer Present Value dollars are needed to match the purchasing power of Future Value dollars. In other words, the Future Value should always be bigger than the Present Value. To calculate bank interest returns, the second formula above can be used:

Future Value = Present Value * (1 + interest rate)number of years

The total opportunity however, needs to include interest and inflation into the picture, so the equation becomes:

Future Value = Present Value * (1 + interest rate – inflation rate)number of years

If inflation exceeds the interest you are receiving, you are effectively paying the bank to store your money. So spare a thought for those poor accountants sweating over the future value of their multi-billion dollar funds and maybe be a bit more understanding when the project you have developed the Project Charter for does not get approval – the returns on investment might simply not be there.

Velopi’s PMP® exam preparation courses cover cost management, including Present Value and the other nine knowledge areas. For more details on these courses, please visit our training page, or contact us directly.

By Velopi Seamus Collins

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