Time Value of Money

Kelvin Ranck, Farm Credit loan officer

You may have heard the phrase “time is money”. This statement is true in more ways than one. While normally this is referring to the fact that time is valuable, it is also true regarding the fact that over time, the value of money can both increase and decrease from its present value.

There is a greater benefit to receiving money today, than there is toreceiving that same portion of money at a later time. This concept isknown as the time value of money, meaning a dollar earned today isworth more than a dollar earned next year. If you have a dollar today,you can invest it and earn a return on that dollar so it is potentiallyworth $1.10 next year.

To better understand the concept of the time value of money, consider this example:

Your friend offers to give you $100 for your birthday. The friend says that he can give you the $100 today or wait and give it to you in exactly one year from now. Which option would you choose? We would all chose to receive the $100 today. If we receive the money today, we could then use that $100 over the next year to buy corn seed and grow corn silage, or buy a boat and go fishing over the next year, or invest the money and receive interest on that $100. Whatever way we chose to use the money, we have used it to add value to our lives and businesses.

You may be thinking, “This all makes sense, but how does the time value of money effect my business and my profit potential?” Let’s take a look at a few ways in which the time value of money can help us manage our money.

1. Helps inform our investment decisions

The time value of money helps us understand and value the moneysaved/earned through the years from a given investment.

For example: You are considering whether to buy a sprayer to sprayyour corn and tobacco crops. You do not currently have a sprayer, andeach year you pay your neighbor $1,000 to spray the tobacco and corn.It costs $5,000 to buy a sprayer. We might think that if we spend $5,000to buy a sprayer, that in five years we will have paid off the sprayer. But ifa dollar earned today is worth more than a dollar earned next year, thenthe $1,000 saved next year and the year after that is going to be worthless to us than the present value of our $5,000 sprayer.

For this example, let’s say that you can place your $5,000 in an investment and make a five percent return each year. Since five percent is our Return on Investment (ROI), we need to discount the money saved from owning a sprayer by 5 percent each year. $1,000 saved each year over the coming five years is worth about $4,280 to us right now in 2021.

Note: This does not mean that buying the sprayer is a bad idea. The sprayer can be used for more than five years, and after five years the sprayer will have a resell value. The main point is that if we are going to invest $5,000 in a sprayer, we need to be able to save more than $5,000 in the future years, as money earned in the future has less value than money earned today.

2. Demonstrated through inflation

As mentioned in the introduction, the value of money can decrease over time, causing our dollar to be less valuable. When there is a general increase in prices of goods and services, this is called inflation. When the prices of products such as food, fuel, and fertilizer increase, it causes the purchasing power of the money in our checking account to decrease.

For example: You sell some tobacco and receive $5,000. Then over the winter, the price of fertilizer increases. Now your $5,000 tobacco profit can buy less fertilizer than the year before. When we purchase assets such as land or equipment, we are protecting ourselves from inflation. This is due to the fact that while the cash in the checking account is staying the same, our land and equipment is costing more as the years go by.

3. Cost of production

One of the advantages of borrowing money is that we can control our cost of production/operating expenses.

For example: This year we have seen a high rate of price inflation. Many of the normal costs of farming such as fuel, land rent, labor, and equipment have increased dramatically. Imagine how nice it would be to fix your fuel or fertilizer costs for the next five or seven years. Thankfully the cost of borrowing money has decreased. With the interest rates at their current low levels, farmers are able to fix their interest rate and guarantee a low cost of borrowing. So while other costs of farming increase, you can fix and know your cost of borrowing for future growing seasons.

There are many decisions to be made while managing a farm business: How much money to borrow, what equipment to buy, how much money to save, how to invest our money, etc. Understanding the time value of money can help us make these business decisions and better manage our money.

Kelvin Ranck, Farm Credit loan officer