Suppose you’re
selling your business, and it’s worth $400,000. You’re offered $210,000 down
and lump sums of $100,000 at the end of year one and year two. Should you take
the offer?
Most people
know that $1,000 now is worth more than $1,000 a year from now. Here’s why:
1.
Inflation: In a year, a dollar will buy less than it would today.
2. Risk:
Over time, the risk increases that some of the money owed you will not be paid.
3.
Opportunity loss: Funds on hand could be invested and earning more money.
Present
value analysis attempts to quantify these variables. It discounts the value of
future funds by estimating inflation rates, risks of loss, and rates of return
from alternative investments.
Assume you
could earn 2% by investing in a $100,000 CD. Disregarding compounding, in a
year your investment would be worth $102,000. Conversely, if you postponed
receipt of $100,000 for a year and inflation eroded the principal by 3%, you’d
receive the equivalent of $97,000 in today’s dollars. (Note that with 3%
erosion, even the $102,000 CD proceeds would be worth only $98,940 in today’s
dollars.)
In the
opening example, your proposed “investment” (a two-year $200,000 note
receivable) would be far riskier than a CD. To compensate, you might decide not
to accept anything less than an 8% return. A present value table indicates that
at 8%, the discount factors for one and two years are .926 and .857,
respectively. $100,000 times .926 is $92,600; $100,000 times .857 is $85,700.
Thus, in
today’s dollars, the buyer is offering $388,300 ($210,000 down payment plus
$92,600 plus $85,700). Since your business is worth $400,000, you would be
selling for $11,700 less than full value.
A similar
analysis can be applied to any business transaction involving future payments. For
help with the calculations or assistance with any of your business needs, call
us for an appointment.
Maris & Associates CPA's
10512 19th Ave SE #101
Everett, WA 98208
425-338-0414
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