Talking about currency values can give most people migraines who may avoid comprehending a valuable piece of information which is crucial when it comes to investments. Present value of money involves the preference of investors who would rather have a set amount of money right now, instead of waiting to receive the same amount in the future.
The present value of money is affected by factors such as inflationary risks and opportunity costs. First, lets define the future value of money. When we talk about the future value of money, we are referring to the interest a set amount of capital will be worth in the future, this concept can be applied to funds deposited in an interest bearing account.
Now that we have established that the present value of money is very important we can analyze how this value can be affected by economic variables such as inflation which involves a constant rise in price levels in relation to a standard purchase power. In other words, a million dollars today is much more valuable than a million in ten years because inflation may raise the price of goods resulting in diminished purchase power and lost interest.
A simple example to illustrate the situation depicted above could be the following:
Lets imagine someone wins the lottery, sells a property/business or settles a case for monetary compensation. Following any of these situations the recipient will end up getting paid several small installments over a set period. If this is the case the total amount of money will get depreciated as time goes by. Ten years latter the interest that could have been earned (opportunity cost) is lost and since prices may have gone up by the effects of inflation now less things can be purchased with the same capital compared to ten years in the past.
Business or property notes, structured settlements and lottery winnings are all instruments that if properly handled can yield attractive return on investments. Now, in terms of settlements, payments that are due are basically interest that hasn’t been earned yet. When lawsuits and cases are settled, at times the insurance company invests the settlement amount in an annuity (which is a stream of fixed payments which will be received over a specified period). This funds monthly payments, which is a combination of principal and interest derived from the capital invested. It is for this present value factor that insurance companies pay in installments rather than pay the entire amount. This makes insurance companies extremely profitable in a settlement case.
As you see whoever takes advantage of the present value of future payments first (whether it is you or insurance companies) get the full benefits of a precious investment.