What Tomorrow’s Dollar Is Worth

Lefty Ruggiero badly wanted Tony Conte, an FBI agent he took for his business partner, to buy himself a bar. To look solid. Pistone gives his reasoning almost word for word; in my retelling it goes like this. Look, says Lefty, a joint in New York costs fifty thousand, but you can buy it for seven and a half up front and pay off the rest bit by bit out of the profits. And here an ordinary bar with a kitchen costs fifteen thousand or so. You put down two and pay off the rest as you go. You put your own machines in, and the whole take is yours.

Tony answered that everyone here was doing fine and nobody would sell his place. The deal fell through. But Lefty, without knowing it, had given a lecture on finance. Let’s take it apart.

Price Is the Future

What does a man who pays fifty thousand for a bar actually buy? The chairs? The counter? No. He buys the profit the bar will bring in over the years to come. Any business, any share, any house is worth exactly what the money it will bring tomorrow is worth today.

And what is that money worth today? Less. A dollar that will arrive in a year is worth less than a dollar today: if you had it now, you’d put it in the bank and in a year get it back with interest. So to find out what a future payment is worth today, you have to shrink it by the interest for every year of waiting. This is called discounting, and what you end up with is called present value.

The sum is easy. At ten per cent a year, a hundred dollars that will come in a year’s time is worth about ninety-one today. Wait two years—about eighty-three. Ten years—less than forty. The further off the payment and the higher the rate, the less it’s worth today.

People worked this out long ago. As early as 1202, Leonardo of Pisa, known as Fibonacci, in his Liber Abaci looked at how to compare money that arrives at different times. Historians of finance count him among the first to reckon this way. The merchants of Pisa and Genoa wanted to know which was better: a hundred now or a hundred and twenty in two years. The answer, as today, depended on the rate.

The Seller Who Gives Credit

Back to Lefty. “Seven and a half up front, the rest out of the profits.” What’s going on here?

The seller of the bar agrees to get most of the price not now but some time later, out of whatever the buyer earns. In effect, he’s lending to the buyer. And if he’s smart, he’ll ask for more than fifty thousand: forty-two and a half thousand in a few years’ time is worth less today than forty-two and a half today. And if the buyer goes bust, the seller may get nothing at all. Paying “out of the profits” means paying with something that may never exist.

Lefty didn’t think about that. He saw one thing: you can become the owner of a bar for seven and a half. That’s how everyone who buys on instalments reasons. He looks at the down payment and doesn’t work out what all the rest really costs.

Seventeen Years

Present value has another side, too, and it isn’t about money.

In 1910 Morello was sentenced to twenty-five years. Even with time off for good behaviour, Dash writes, he couldn’t get out before 4 December 1926, some seventeen years away. A sentence like that, Morello wrote to his wife, could drive a man out of his mind.

Freedom that will come in seventeen years is worth almost nothing to a man. Its “present value” is negligible. But a chance to cut the sentence right now is worth a fortune. That’s why the family raised fifty thousand dollars for the appeal lawyer we talked about earlier. People always pay far more for what’s near than for what’s far off. Bankers call this the discount rate. For prisoners it runs very high.

Debt Without End

And now for the strangest thing ever invented in bonds. A debt that never has to be repaid.

In the middle of the eighteenth century the British government gathered its scattered debts into a single bond and called it consols. There was no need to redeem them: they had no maturity date. The government promised to pay interest for ever—first three and a half, then three per cent a year—and could buy the bonds back whenever it liked, but wasn’t obliged to. People bought them, sold them, left them to their children and grandchildren. The British Treasury bought back the last consols only in 2015. Interest on that debt had been paid for more than two hundred and sixty years.

Even for ever, as it turned out, comes to an end.

What is a promise to pay three pounds a year for ever worth? The sum is surprisingly simple: divide the payment by the rate. At three per cent—a hundred pounds. At six—fifty. Rates go up, the perpetual bond gets cheaper. Rates fall, it gets dearer. Any bond with fixed payments behaves the same way, all else being equal: the promised payments are the same, but the return demanded of them is different. With a perpetual it’s just easier to see. But perpetuals aren’t all the bonds in the world. A coupon can be floating and adjust itself to rates. It can be tied to inflation. The borrower may have the right to buy the debt back early. Or rates may have gone up, but over that same year the borrower has become more reliable, and less is demanded of him than before. Then do the sum again. And don’t confuse the central bank’s rate with the yield the market demands from a particular bond: they’re relatives, not twins.

What the Rate Will Be in Ten Years

One last thing. There isn’t just one rate. Borrow for a week and you pay one thing, for a year another, for thirty years a third. Line the rates up by term and you get a curve, and its shape shows what the market thinks about the future. Usually the longer the term, the higher the rate: whoever waits longer and risks more wants more. If short money suddenly costs more than long money, it often means the market expects hard times, after which rates will fall.

How the Don Paid in Advance

Once the mill owner made the Don an offer: pay for the whole year’s oil in advance, in one sum, and get five per cent off. I was delighted: five per cent is good money.

The Don picked up a pencil. We received the oil evenly, all year round. So if we paid for everything in January, on average we’d be handing over the money six months earlier than usual. Five per cent for six months is roughly ten per cent a year. The bank was giving us three on deposit at the time. “So the mill is paying us three times what the bank pays for our money,” said the Don. Then he thought some more and asked: “And if the mill burns down in March, who gives me back the money for the other months?” We paid six months in advance, not a year. And asked the mill owner to insure his warehouse.

The Bottom Line

Buying on instalments is a loan, and it’s never free, even when nobody mentions interest. And keep the rule “rates up, bond down” for fixed payments. Where the payments float, do the sum again.