Time Value of Money

Time value of money is a concept that money today is worth more than the same amount in the future because of its potential earning capacity. A dollar today has a higher value than a dollar twelve months from now. That is because if you have a $1.0 today and can earn 10% on it then at the end of the year you would have $1.10. Or think about it in reverse: one dollar next year is only worth about 91 cents today (91 cents invested at 10% interest rate will yield one dollar in 12 months). The earning (interest) rate is often called "discount rate".

How is time value of money relevant to cash flow transactions? Let's look at private mortgage notes. The "discount rate" that the funding sources use determines the amount of money they would offer you for your notes. The discount rate that the funding sources use depends on the potential earning that they can get if they invest the money elsewhere and the level of risk associated with the notes. Low credit rating and low down payment by the buyer of the property represents higher risk. The buyer may not be able to make future payments and would likely walk away because he hasn't had much equity in the house. This risk will translate into a higher discount rate required by the funding sources. It doesn't mean that you cannot sell mortgage notes if the payor's (the buyer of the house) credit is bad. It just means that you will see a lower offer for your note. If you are lucky to have notes created years ago when the rate was in the 7-8% range, the discount on those notes would be minimal in the current low (4-5%) interest rate environment - all else being equal. As the interest rate rises so will the discount rate, and the value of the notes will decline.

Let's look at another cash flow type: life insurance settlement. You are the beneficiary of a life expectancy policy worth $1,000,000 and the life expectancy of the insured is 10 years. You can sell the policy for cash now if you need money for medical expenses or other emergencies. If the discount rate is 12% you would receive $320,000 because at that rate, the value of $320,000 today is the same as that of $1,000,000 ten years from now. The above rate is purely for demonstration purposes. The process to determine the discount rate for this type of cash flow is fairly complex. 

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