Tuesday, August 02, 2011

What is the value of $40 million?

As Poo-Bah says, "Merely corroborative detail, intended to give artistic verisimilitude to an otherwise bald and unconvincing narrative:" Let's consider how much $40 million is really worth when you spread the payment over a period of time.

As economists and investors will tell you, there is a time value associated with money.  To prove this, ask yourself whether you would rather receive $40 today or a year from now.  Of course, you would want it today, as you can use or invest it today, whereas its future value is less.  As the person who owes you money, I'd rather pay it to you in the future than today, for exactly the same reason.

There is a formula (above) that tells you the time value of money.  It is based on the interest rate you could otherwise earn on that money.  In the nonprofit world, that is the rate you can earn on your endowment.  In 2010, the average return on endowments was about 12% according to the Chronicle of Philanthropy.*

So, if an organization postponed paying $40 million for a year, it was able to deprive the payee of the right to that money for that period, reducing the effective cost to the payer (and the value to the payee) to $35.71 million ($40 million divided by 1.12).

But this is between friends, so let's put that aside, and start all over with $40 million, looking forward from today.  What if the organization reduces its insurance reimbursements by $40 million over the next year or two?  We divide the $40 million by 12 or 24 months, apply the relevant monthly discount factor (12% divided by 12 or 24) and discover that effective cost to the payer (and the value to the payee) has dropped to about $38 million.

Meanwhile, the company has already taken a charge against earnings of $40 million.  That this is the appropriate accounting treatment should not be doubted.  But accounting treatment is not concerned with the time value of the money.  It deals in nominal dollars.

But remember how you felt, above, knowing in your heart that a check today is worth more to you than one of the same amount next year.

* We can quibble about the appropriate discount rate.  Perhaps we should be using the interest rate faced by small businesses or individuals on their credit cards or other lines of credit.  Perhaps we should consider the inability of some small businesses to borrow at any rate, implying an infinitely high cost of money.

1 comment:

Anonymous said...

PV works for the finance folks, but I think your inference from the previous post was more compelling: if I reap an additional $200M per year for 15 years, and then reduce my benefit by $40M over some future period, aren’t I still more than $3B ahead?