Five years ago I lent my son £1,000 and as I never really expected to see my money again and had forgotten about the loan, it came as a nice surprise to suddenly find that he had recently credited my bank account for the full £1,000 borrowed all those years ago.
The loan was repaid in the same week that the Office for National Statistics published data showing that the Consumer Price Index (CPI) was standing at just over 3%. The CPI measures the rate at which the prices of commonly purchased goods and services have changed over the previous twelve months. Consequently, 3% is quite high in comparison to previous years.
So what has the inflation rate got to do with my loan being repaid? The answer is that whilst I was very happy to have my money repaid, the fact that prices are now higher than they were when I lent the money means that the buying power of my newly returned £1,000 is somewhat less than it was five years ago. Accountants have a way of calculating the value of money to be repaid in the future in today’s terms, this is called Present Value. To complete a calculation they need to assess the interest earning potential and the inflation rate that applies during the period of any loan. The higher an interest or inflation rate, the lower the value in the future.
Using an online calculator and assuming an average annual inflation rate of 3% and an average building society interest rate of 1.5% had applied during the five years in which the loan was outstanding, I calculated that the £1,000 repaid had cost me nearly £200 and that I would have needed the repayment to be about £1,225 for me to ‘break even’ on the deal.
Lending money to members of one’s family is rarely a commercial success but the principles outlined above are highly significant in the business world.
Leasing is one of the most popular means by which businesses acquire capital equipment and one important feature of most equipment leasing agreements is that rental payments are fixed for the duration of the contract, commonly up to five years. The key here is that all future payments will be based on the value of money applying when the deal was activated, no matter what happens to inflation or interest rates in the future.
By way of example, if a company signed a leasing deal involving monthly rental payments of £500 over a 5 year period, the total amount repaid would be £30,000 (£500 x 60 months). But assuming that the inflation rate applied during the period of the lease was 3% every year, the real cost (present value) of all the rentals being repaid over the five years would be reduced to £27,895. If we further assumed that our company could generate a return on its cash that equates to 12% per annum (the average return on capital for UK businesses) the real cost of the lease would fall to just £21,280.
Whether you’re borrowing money from a relative or signing a lease agreement to acquire capital equipment, any deal on offer could be considerably enhanced if payments are fixed at the outset.
Andy is an experienced sales and finance professional with over 25 years’ experience in sales aid leasing. Andy is widely recognised as an expert in business finance and has in recent years focused his attention on developing partner sales teams develop an understanding of how businesses secure project financing. His training programme – Finance Unlocked – is a highly rated customisable course and is offered at no cost to partners.
If you’re interested in helping your sales team overcome finance-related hurdles during the selling cycle, please get in touch with Andy on 07966 114 243 or email here.