The Dollar of the Future
By Mike Hillyer | Related entries in Financial PlanningWill the dollar of the future be made of paper? Will it be in a chip in your finger? I can’t say, but I can tell you one thing: it will be worth less than the dollar of today.
In the mail today my wife and I received yet another letter from Reader’s Digest advising us that we were moments away from winning a million dollars (as long as our name was drawn from the millions of Reader’s Digest subscribers). Then, just to really get us excited, we were asked to choose whether we wanted to receive our winnings in a big event or an informal dinner. The next question was the kicker: did we want a $1,000,000 lump sum or a cheque for $8333.33 each month for the next 240 months/20 years?
Well that’s an interesting question: $8333.33 * 240 = $1,999,999.20 or almost two million dollars! So given the choice between two million dollars and one million dollars, why would you choose the one million dollars (besides the desire to buy a big item right away)?
The answer is Net Present Value. Net Present Value is the value of future dollars in today’s dollars, and it is a value often used when deciding whether to make an investment. If you like formulas it looks like this:
Image from Wikipedia under the GNU Free Documentation License
In case you prefer spreadsheets, you can use the NPV() function of Excel to accomplish the same task, see the last entry at http://www.functionx.com/excel/Lesson12.htm for a quick tutorial on how to use the function. The short version is to pass the discount(inflation) rate followed by a comma and a range of cells that represent future payments.
If we assume an inflation of 1.5% (the average Canadian rate from 1990 to 2001 according to http://globalis.gvu.unu.edu/indicator_detail.cfm?country=CA&indicatorid=152), our two million dollars of future payments will only cost Reader’s Digest around $540,000 in today’s dollars. In other words, Reader’s Digest benefits greatly when you choose a deferred option because they need only set aside a relatively small amount now to cover making the $8333.33 payments for the next 240 months. In addition, consider this: according to the Bank of Canada inflation calculator, if you had chosen the regular payments back in 1985, your $8333.33 checks today would only be worth about $4900 1985 dollars, as far as buying power is concerned.
This is of course a very rough figure, since we cannot predict inflation rates, but it does emphasize that your money is worth more today than it will be later.
So how can you use NPV to your advantage? Well the first thing to do is keep it in mind when you do win a lottery that offers a lump sum vs. regular payments choice. The next thing to do is keep NPV in mind when looking at savings and investments. Remember first that the interest you earn is offset by inflation, so keep in mind what your investment is worth in today’s dollars when working the numbers. Also keep in mind that because of inflation and compound interest, it is best to start early in your savings and investments while your money is worth more AND has more time to grow.
This entry was posted on Wednesday, March 23rd, 2005 and is filed under Financial Planning. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.
March 23rd, 2005 at 10:53 am
Great post, Mike. Nice to see someone able to put macroeconomics in a functional setting.
March 23rd, 2005 at 11:57 am
Is 1.5% pa the appropriate discount rate to use? Presumably their investment should be able to outpace inflation. Inflation also represents the loss in value of a dollar (ie it’s a -1.5% growth), while using it in an NPV calculation implies it’s a growth number.
Sean
March 23rd, 2005 at 12:10 pm
Heh, I always used to pull a similar trick back when I worked at a Union Hall. This was when ‘Cash for Life’ tickets just started selling. I asked people if they’d prefer $1,000,000 right now, or $1000 a week for the rest of their lives.
Each and every one would choose $1000, not even thinking that with a decent investment account, that million would be worth far more money in both the long and short runs.
Of course, now that I remember the budgeting abilities of my past co-workers, the $1000 a week may have been a better option. You can’t fritter that away and be left with nothing for longer than a week. =)
March 23rd, 2005 at 12:14 pm
Sean: My intent was not to determine the amount that RD would have to set aside, just the present value of the sum of the payments. Naturally they would find an investment that would outpace inflation.
As for using inflation in an NPV calculation, I’m basing this on a managerial accounting course of three years ago, so I may be incorrect. Do you have a more accurate number for the NPV of their payments?
March 24th, 2005 at 8:57 am
I’m just basing my comments on an Engineering economics course I took too many years ago
The rate you use depends on what you’re comparing it against. In this situation, the inflation rate is fairly arbitrary since you can’t invest in something that will return the inflation rate.
To specifically address what RD would have to put aside, the discount rate would be what they’re investing their money at. This would be a savings account, treasury bills, or if they’re speculating, the stock market. Something like 2.5% would be more realistic, since you can get GoC treasury bills at those rates: http://www.bankofcanada.ca/en/tbill-look.htm
My point is that inflation is a negative growth. Its use in NPV calculations would be more appropriate to answer something like “How much money would I have to put under my mattress today in order to buy a car every year for the next N years”. All other things being equal, the purchasing power of your cash reserves will decrease because of inflation.
This article also has a nice tie in to “how much money will I need to retire?”.
March 24th, 2005 at 11:48 am
The Wealthy Blogger Finance
Mike from The Wealthy Blogger just posted a great article on the basic financial decision-making tool called Net Present Value (NPV). For those of you who don’t know how to make basic investment decisions, go check out this article now.
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