Future payments

What Are Future Payments?

Future payments refer to monetary sums or benefits that are expected to be received at a specific point or over a period in the future. These payments are fundamental to financial valuation, as their worth today is often less than their face value due to the Time Value of Money. Understanding future payments is crucial for individuals, businesses, and governments in areas such as Investment Analysis, debt management, and retirement planning. The concept forms the bedrock of various financial calculations, including the determination of Present Value and Future Value.

History and Origin

The concept of valuing future receipts has roots in ancient civilizations, particularly in the understanding of interest and lending. Early forms of discounting, which is the process of determining the present value of a future payment, can be traced back to Babylonian practices involving loans and agricultural yields. The formal mathematical framework for dealing with future payments evolved significantly during the Renaissance, as commercial activities and sophisticated financial instruments became more prevalent. Clergy in 17th-century England, facing financial challenges with long-term land leases, notably used "discounting tables" to calculate the present value of future lease payments, demonstrating an early practical application of these principles in complex financial situations. This method helped them to determine upfront fees that would be acceptable to tenants while addressing the cathedral's financial needs.⁴

Key Takeaways

• Future payments represent money or benefits expected to be received at a later date.
• Their value is typically assessed using financial models that account for the Time Value of Money.
• Common examples include interest, dividends, pension disbursements, and bond principal repayments.
• Accurate forecasting of future payments is essential for sound financial planning and investment decisions.

Formula and Calculation

Future payments are often components within broader financial formulas used for Valuation. For instance, when calculating the present value of a single future payment, the formula used is:

$PV = \frac{FV}{(1 + r)^n}$

Where:

• (PV) = Present Value
• (FV) = Future Value (the future payment)
• (r) = The Discount Rate (or interest rate)
• (n) = The number of periods until the future payment is received

For a series of equal future payments, such as an Annuity, a different formula is applied:

$PV_{annuity} = PMT \times \frac{1 - (1 + r)^{-n}}{r}$

Where:

• (PV_{annuity}) = Present Value of the annuity
• (PMT) = The amount of each payment (a future payment)
• (r) = The discount rate
• (n) = The number of payments

These formulas highlight how future payments are critically evaluated in today's terms.

Interpreting Future Payments

The interpretation of future payments largely hinges on their timing and certainty. A larger future payment is generally more desirable, but its value is significantly diminished the further out in time it is expected, or the higher the associated Discount Rate. For instance, a guaranteed Cash Flow from a highly-rated bond is interpreted differently than a speculative dividend payment from a volatile growth stock. Investors and analysts often project future payments to assess the profitability of investments, the sustainability of debt, or the adequacy of retirement savings. The reliability of the projection and the appropriate discount rate are key to accurate interpretation.

Hypothetical Example

Consider an individual, Sarah, who is expecting two future payments. The first is a lump sum of $10,000 from a matured certificate of deposit (CD) in exactly one year. The second is a $10,000 bonus from her employer, expected in three years, contingent on the company meeting certain performance targets.

To evaluate these future payments, Sarah considers the Time Value of Money. Assuming she could earn a 5% annual return on her investments:

1. CD Payment (1 year out):

   • FV = $10,000
   • r = 0.05
   • n = 1
   • $PV = \frac{\$10,000}{(1 + 0.05)^1} = \frac{\$10,000}{1.05} \approx \$9,523.81$

2. Bonus Payment (3 years out):

   • FV = $10,000
   • r = 0.05
   • n = 3
   • $PV = \frac{\$10,000}{(1 + 0.05)^3} = \frac{\$10,000}{1.157625} \approx \$8,638.38$

Even though both future payments are for the same nominal amount, their present values differ significantly due to the timing and the opportunity cost of money. This exercise helps Sarah understand the true present worth of her expected future income.

Practical Applications

Future payments are integral to numerous financial domains:

• Corporate Finance: Businesses use projections of future payments, such as anticipated revenues and operating expenses, in Capital Budgeting decisions and Financial Modeling. This helps them evaluate potential investments and projects by estimating their future cash flows.
• Investing: Investors analyze expected future payments like Dividends from stocks, interest payments from Bonds, or distributions from real estate to make informed investment choices. Net Present Value calculations heavily rely on future payment streams.
• Lending and Debt: Lenders determine loan terms, including monthly Loan Amortization schedules, by calculating the present value of future principal and interest payments.
• Retirement Planning: Individuals plan for retirement by estimating their future expenses and projecting income from pensions, annuities, and social security. The IRS, for example, provides detailed guidance on the tax treatment of these future payments through resources like Publication 575.³
• Financial Reporting and Regulation: Companies are often required to disclose material future payment obligations, such as lease commitments or pension liabilities, to provide transparency to investors. Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) mandate disclosure of contractual obligations in company filings to ensure investors have a clear understanding of future financial commitments.²

Limitations and Criticisms

While essential, the analysis of future payments is not without limitations:

• Forecasting Uncertainty: Projecting future payments inherently involves assumptions about economic conditions, market performance, and specific company or individual circumstances. These assumptions may prove inaccurate, especially over longer time horizons, leading to significant deviations between expected and actual payments.
• Discount Rate Sensitivity: The chosen Discount Rate can dramatically alter the present value of future payments. Small changes in this rate, which often reflects risk and inflation expectations, can lead to large swings in valuation outcomes. For instance, rising inflation can erode the purchasing power of fixed future payments, impacting the real return for investors in fixed-income securities.¹
• Unforeseen Events: Future payments can be impacted by unforeseen events such as economic downturns, regulatory changes, or personal financial crises, which are difficult to account for in initial projections.
• Liquidity Risk: Even if future payments are certain, a lack of liquidity (the ability to convert an asset into cash quickly without affecting its market price) can pose challenges if immediate funds are needed.

Future Payments vs. Present Value

Future payments and Present Value are two sides of the same financial coin, both central to the concept of the time value of money. The primary difference lies in their temporal perspective:

Confusion often arises because financial analysis frequently requires converting future payments into their present value equivalents to enable fair comparison and decision-making.

FAQs

Q: What are common examples of future payments?

A: Common examples include regular interest payments from Bonds, quarterly Dividends from stocks, monthly pension or Annuity disbursements, salary, and the principal repayment of a loan at its maturity.

Q: Why is it important to consider future payments in financial planning?

A: It is crucial because the value of money changes over time. A dollar today is worth more than a dollar in the future due to its potential earning capacity. By evaluating future payments in today's terms (their present value), individuals and organizations can make informed decisions about savings, investments, and debt.

Q: How does inflation affect future payments?

A: Inflation erodes the purchasing power of money over time. Therefore, fixed future payments will be able to buy less in the future than they would today. Financial planners often consider the impact of inflation when projecting real (inflation-adjusted) future payments and their present values.