Time Value of Money
By: JOHN L. NELSON
Spring/Summer 1996
As children instinctively know, it is better to have something today rather than tomorrow. However, as we grow, we are taught about the virtues of patience and waiting, and how delayed gratification can actually be better for us than receiving something right away. In spite of these lessons, the desire to have something today rather than tomorrow remains with us throughout adulthood. This is especially true when it comes to money. In fact, society has developed principles concerning the time value of money that encourage this way of thinking. These principles are important in resolving divorce proceedings.
It's Better To Have a Dollar Today Than Tomorrow
The time value of money principles are based on the fundamental proposition that it is better to have a dollar today than tomorrow. If someone forgoes a dollar today, and agrees to receive it at a later date, that person will be entitled to compensation in the form of interest for delaying receipt of the dollar. Similarly, a person is willing to receive a dollar today and pay it back at a later date along with additional amounts in the form of interest.
When comparing the benefit of receiving that dollar today rather than tomorrow, the most important factor is the interest rate (also called the discount rate). The following table shows how much the right to receive $10,000 five years from now is worth today, based on various interest rates.
Interest Rate Present Value
As can be seen, the interest rate chosen can have a significant impact on present value. Also, the higher the interest rate, the greater the difference between present and future value.
Looking at the concept in reverse, the following table shows how much someone would have to pay in five years in order to receive $10,000 today.
Interest Rate Future Value
Note that to calculate the future value, you do not just add five years of interest onto the $10,000. That is because interest is generally compounded, which means that you pay interest on the interest. For example, at 10% interest, the future value of $10,000 is $11,000 after one year (($10,000 x 10%) + $10,000), and $12,100 after two years (($11,000 x 10%) + $11,000).
Time Value of Money Principles Are Used in Marriage Dissolution Proceedings
Time value of money principles are used to resolve property award and spousal maintenance disputes. For example, assume that there is one asset that a divorcing couple owns, such as a business, that exceeds the combined value of the couple's other property. If the business is awarded to one spouse, the other will be entitled to a cash payment to equalize the disparity in the value of each party's property award. Frequently, the cash equalizer payment is paid in installments, with interest, to compensate the spouse entitled to the payment for the delay in receiving the entire payment. Parties must agree on the amount of the payment required today, timing of future payments and applicable interest before calculating the actual payment amount.
Time value of money concepts are also used in spousal maintenance negotiations. Let's assume that the parties agree that one spouse (payee) is entitled to a monthly spousal maintenance of $1,000 per month for the next 60 months; however, the payee agrees to forego those 60 monthly $1,000 payments in exchange for an immediate lump-sum payment. The amount of the lump-sum payment will be less than the aggregate monthly payments since the payee will receive the entire amount today, rather than amounts at later dates. After the parties agree on an interest rate, the amount of the lump-sum payment can be calculated. In cases involving permanent spousal maintenance, the payee's life expectancy needs to be considered when making the time value of money calculations.