Every so often I’ll be browsing some personal finance blogs and I will see somebody who said they would rather have $Xx/month then $Xxxxxx as a lump sum. Sometimes they are correct in which they would prefer and other times they are not even close and clearly making a fool of themselves.

Present value is essentially the current value of money you would receive in the future. The value is different from what it is worth today because there inflation and the opportunity cost of investing (the amount of return you could have made on your investment if you had the money before).

For a lump sum of cash determining the present value is easy. There are no future payments and your receiving the cash right away so the present value is equal to the current value. It is even easier to understand with an example: If I give you $1,000, how much is that worth to you? $1,000 duh!

For passive income it is different. First you must determine whether or no the passive income will expire, ie. stop earning money. For the sake of simplicity we will assume that the payments will never stop. So if you are going to receive a paycheck each year how much would it need to be to equal a lump sum of $1,000.

First we need to determine the interest rate that you could earn on your money. Lets say you can earn 10% per annum on your money, so in a years time the lump sum will equal $1,100 (1000*1.10). Still with me?

Good. So now that we have an interest rate of 10% how much do you we need to receive each year to have the same present value as the $1,000. All we need to do is solve a little equation.

Present value = (yearly income) / (interest rate)

We know the present value should be equal to the lump sum, so thats $1,000. And the interest rate is 10% or 0.10. So put those numbers in and the equatino looks like:

1000 = (yearly income) / (0.10)

rearranging we get

yearly income = PV*interest rate = 1000*0.10 = $100

So $100 a year for the rest of your life is equal to $1000 today.

So what do you want more $1,000,000 or $100,000/year for the rest of your life? The choice is obvious, you call me when somebody gives you this offer and for a small management fee I’ll tell you what to do Or you can just figure out that these two choices are equal and it shouldn’t matter which one you take.

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Filed under: Math, Passive Income, Portfolio Income