in understanding present value, we should first take a look at what actual definition of present value given by Investopedia: “The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they are earnings or obligations; also referred to as ‘discounted value’.”—Investopedia.com
Whether your choice of financial software has this calculation embedded into the design or not, it CAN be a useful method to explain your client’s balance sheet at your next meeting.
First let me briefly explain how present value is used for the calculations in the financial planning software and the Household Balance Sheet.
The Household Balance Sheet is the focal point of the Goal Achievement Report to the client. As a discounted cash flow model, the Household Balance Sheet performs present value calculations on all future income and spending goals to represent those items in today’s dollars. We calculate the annual future cash flows from the start date to the end date of each anticipated income resource or future goal. If an item has an annual adjustment factor applied, such as inflation, we first increase the amount entered for the item by the annual adjustment factor from the current date forward, then discount those future dollar values back to today’s dollars.
If an items’ cash flow is considered pre-tax dollars, we will calculate the total present value of the deferred income taxes on those cash flows and deduct that amount from the total actuarial present value to get the Actuarial Net Present Value of the item.
Bit of garble isn’t it? Here’s how you need to understand present value to explain it to you client.
To understand in its most pure and simplest form, if you had a choice of being paid $1,000 today or $1,000 a year from now, which would you choose to accept? You accept the $1,000 today because you could invest it and receive an additional return over the year. Remember that inflation will eat off some of that $1,000 and so in a year from now, you might have $997. This is why more people prefer to get their money sooner than later. In other words, present value is today’s value of an amount of money in the future
For the Household Balance Sheet in goalgamiPro, the calculation of discounted or present value is extremely important because your client can fully see and understand their purchasing power at a point in time and where they fall short, meet, or exceed their expenses/goals--all by discounting future items back to today’s dollars.
What is most crucial is the ability to connect with their client’s goals and expense by explaining to them what they can really afford---today.