Life is about decisions, whether they relate to your work, business or
personal life. Often ignored is the interplay between all these areas,
and the fact that a little interdisciplinary thinking can go a long
way. This might sound obtuse, but many important decisions can be made
easier by thinking simply, and a bit differently.
Before we do, a note about value, and 'utility'. Business is about
creating value. Our personal lives (according to economists) are about
maximizing our utility, where utility is simply a measure of the
happiness or satisfaction gained from a good or service.
Think of it this way, and business is considered first. If shareholders
(either owners or investors) could create more value themselves using
other means, why bother running or investing in a business? Assuming we
don't all have a perpetual income stream it comes back to this - if you
don't create value in today's economy, you'll be forced to do one of
two things. Change how you do things, or cease to exist. For business
the value question is rather important.
People have it a little easier in some respects. Creating maximum
utility is an incentive in and of itself. In the end, we all want more,
whether it is revenue and growth for business, or old-fashioned utility
in our personal lives.
To get more, we return to the decisions mentioned earlier, as all the
decisions we make have a direct impact on both value creation and
utility maximization, in particular those related to finance.
Successful strategic management (the direction you want to take the
business) is supported by your investment policy (choosing which
projects to undertake) and your financing policy (how you fund
everything). Linked to all of this is risk management, or how you
handle the risks associated with these financial decisions.
Personally, financial decisions influence your quality of life, and
your ability to enjoy the things you want. Once again we are back
looking at the study of incentives - how people get what they want, or
need, especially when other people want or need the same thing. In this
case, it's maximum utility.
One of the cornerstones of modern finance assists us in understanding
which decisions to make, and it is equally applicable to business and
personal finance. Its known as the time value of money. Simply put, $1
today is worth more to you than $1 received in the future. Why? Money
has a time value because of interest rates, no matter how measly,
making $1 today more valuable than $1 received at some time in the
future because it can be invested today to provide a return. The income
from the investment will in turn, make the dollar you get today worth
more than the one promised you in the future. Perhaps an example best
illustrates the point.
Anne is offered the choice between $100 now, and $100 in a year's time.
She takes the cash now, and invests it in a security (or bank) yielding
8%, and in a year has $108, which is clearly more than if she deferred
taking the money at the start.
Again, this comes back to the incentives mentioned earlier. Interest
rates are paid because someone else can use your money now, and they
are prepared to pay you a return for the privilege of doing so, which
is in truth a premium for taking the risk of giving your money to
someone else. With business, this concept is part of what is known as
the Sharpe-Lintner Capital Asset Pricing Model (CAPM for short),
allowing people to work out, in today's terms, the value of future cash
flows on any project or decision requiring investment. Widely used,
this concept varies in appearance and complexity, from sophisticated
models developed by General Electric to the small business owner using
the 'NPV' formula in an Excel spreadsheet.
There is another side to this discussion, and it's slightly more
personal. The time value of money can apply to you, and specifically,
your utility. To understand how, we need to look at things the other
way around and get a handle on the incentives of everyone involved.
Think of large personal assets you might have, like a structured
settlement. The agreements reached in setting up the settlement left
you with a sense of security for the future and continuing, dependable
payments over time. Comfortable. Hmm. Let's look at the incentives.
Think like they do. The illusion is that you will be better off down
the track with the settlement. The problem is, they don't want you to
have all your money now because they understand the time value of
money. Its worth more to them, and they bank on the fact that you
haven't given it a second thought.
Remember that structured settlements are designed so that the paying
company get the maximum benefit from the time value of money. This
doesn't happen by accident or through some amazing act of benevolence
driven by concern about your long term well-being. It's pure market and
negotiating power. Considering the time value of your settlement, the
incentive is for them to keep your money as long as possible to
maximize their value growth.
The intent of this discussion is to make you think. Consider the time
value of money in your personal life. How much value is there for you
in holding first-mortgage on a property for 20 years, compared with
maximizing your utility? How much utility is your monthly settlement
check going to provide you in 10 years? Just think about increases in
the cost of living over the next fifteen years, and how the monthly
check stands up.
Avenues exist in today's marketplace for you to better utilize these
high-value assets like structured settlements and real estate notes.
Naturally, decisions to do so should not be taken lightly, treating
your largest assets as whimsically as an ATM card. Whether in business
or in your personal life, always consult a diverse range of industry
professionals to increase the amount of information and knowledge
brought to bear on any decision. As mentioned at the start, risk
management is an important part of any decision making process.
Remember the time value of money. It can be used both for and against
you. And find out which way it is being used, just look to which party
has the larger incentives.
