Understanding the Time Value of Money and How It Affects Construction Management

August 26, 2022 by Michael Gober & Denis Gritsiyenko

In today’s financial climate, it’s more important than ever to be smart with your money. As a construction manager, do you consider the time value of money when choosing your projects?

If you don’t, you should start now.

If you haven’t a clue what the time value of money in construction management is, don’t sweat it — we have you covered.

Keep reading to learn about the time value of money, present value vs. future value, and how you can use this information to help you make wise choices for your business.

CM Fusion: Our Construction Cost-Tracking Tool Helps Clarify Your Budget to Effectively Plan Your Cash Flow
What Is the Time Value of Money?
1. Why It’s Important To Understand the Time Value of Money in Construction Management
Present Value vs. Future Value
An Example of Using the Time Value of Money in Construction To Help You Make Business Decisions
CM Fusion’s Cost Tracking Software Makes It Easy To Keep Up With Your Construction Spending and Optimize Your Investments

CM Fusion: Our Construction Cost-Tracking Tool Helps Clarify Your Budget to Effectively Plan Your Cash Flow

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Our cost-tracking tool can provide data that helps you know the exact state of your budget, allowing you to better manage your cash flow. When considering the time value of money in construction management, this helps you know if you can afford to take a particular job.

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What Is the Time Value of Money?

The time value of money is the idea that an amount of money is worth more right now than the same amount will be worth in the future. Because of the money’s earning potential, it’s better to have cash on hand rather than expecting it at a future date.

Money can only grow when you invest it. So if you have to delay the investment because you are expecting that money in the future, an opportunity is lost.

The formula for calculating the time value of money considers:

The amount of money
The future value of the money
The amount that money can possibly earn; and
The time frame

You may also hear the time value of money referred to as the present discounted value.

Why It’s Important To Understand the Time Value of Money in Construction Management

Construction project managers should fully understand the concept of the time value of money. That’s because construction projects have cash flows that occur in the future.

General contractors always want to make payments as late as possible because future money costs less than today’s money — the goal is to keep as much cash in their reserves as they can. If you have retention money in the amount of 10%, it will cost you much less to pay that out in a year.

The time value of money and construction project evaluation go hand-in-hand. Knowing how much cash must be laid out over time or when you can expect a return on investment can help you decide if the job is worth your time and funds.

Present Value vs. Future Value

Present value and future value are concepts that can help construction managers decide if they want to invest in a project. They both deal with the fact that the value of money changes over time due to:

Inflation
Interest; and
Other factors

For example, with today’s high inflation rates, you can’t buy as much with $500 as you could ten years ago. Conversely, that money has more purchasing power now than it will ten years from now.

To put it simply, present value is what future money is worth today and future value is what today’s money will be worth in the future.

Present Value Basics

If you are paid $100,000 for a construction job today, the present value of the money would be $100,000 — because that’s what it’s worth if you spend it right now. However, if you are promised that money when the job is complete, say in a year or so, the present value of the money is not $100,000 because you don’t have it in your possession yet.

To calculate the value of the money in your impending payout, you assume that $100,000 is the total future value of a sum you invest into a current project. So to find the present value of the future $100,000, we have to know how much we would have to invest right now to get $100,000 in a year.

This may sound abstract and confusing, but there’s a helpful formula you can use to collect the data needed to help you make wise decisions about managing construction projects.

How To Calculate Present Value

To find the present value of the amount of money you would invest in a project today, subtract the interest you assume will accumulate from the $100,000. You can do this by discounting the future payment amount by the interest rate for that period.

The equation to find present value can be written as:

PV=FVx(1+i)-n

In this equation:

PV is the present value or original amount of money
FV is the future value of the money
i is the interest rate per period; and
n is the number of periods

If you want to calculate the present value of the $100,000 you will receive in one year from the previous example, assuming an interest rate of 4.5%, plug those numbers into the formula.

$100,000 x (1 + .045)-1 = $956,938

So the present value of a future payment of $100,000 would be worth $956,938 today. Having this information can help construction project managers analyze potential projects and choose those that will be worth the most overall.

Future Value Basics

On the other hand, let’s say you get that $100,000 upfront and invest it at the same interest rate of 4.5%. You want to know what it will be worth one year from now.

Again, there’s a formula that can help you find this information easily.

How To Calculate Future Value

This time you are adding the interest you will accrue to the money you received upfront. The formula will read:

FV=PVx(1+i)n

And once again:

PV is the present value or original amount of money
FV is the future value of the money
i is the interest rate per period; and
n is the number of periods

So to find the future value of the $100,000 you receive today and invest for a year at a rate of 4.5%, you will calculate the following.

$100,000 x (1 + .045)1 = $104,500

By getting your payment up front and reinvesting, you would have an extra $4,500 in your pocket in one year.

The Present Value of a Future Payment

The above examples helped us compare whether it was more valuable to receive the same amount of money now or in the future. But what if you are promised a larger amount if you accept payment down the road instead of today?

For instance, you could take $100,000 today or wait for $150,000 a year from now.

Using the present value equation we learned before, you would calculate:

$150,000 x (1 + .045)-1 = $143,540.67

So if you aren’t desperate for cash, you should agree to accept the future payment as its present value is worth over $43,000 more than the $100,000 you could get today.

An Example of Using the Time Value of Money in Construction To Help You Make Business Decisions

The previous scenario posits a choice between getting money now or in the future. But depending on your position or who you’re working with, you don’t always have that choice.

Many contractors and subcontractors get paid when they have completed their work. This can cause struggles due to cash flow issues — you need to buy materials ahead of time, but you haven’t been paid ahead of time.

Some jobs may allow you to draw on your final payment to buy supplies or hire subcontractors. But others don’t pay anything until installment.

For example, many government agencies such as HUD don’t allow you to take a draw or request payment until the job is complete.

In cases like this, you are spending your own money and waiting to get it back. With inflation rates as high as they are these days, that can be costly.

If you can choose between jobs, knowing the time value of money in construction management and the formulas for present value and future value will help allow you to make the most fiscally responsible decisions.

If you are choosing between a HUD job that will pay later or a private sector job that will pay now, plug in the money amounts, interest rate, and the number of periods to truly compare the two. In construction, every penny counts, so you should know exactly what your money is worth.

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