In this post we will talk about How to think and calculate Net Present Value of a transaction involving Financial Payment , and why its important to understand the concept .
Consider the following Example :
You have to lend Rs 1,00,000 to one of your friends and He is offering you following choices .
Choice 1 : He will pay you Rs 18,000 per year for next 10 yrs .
Choice 2 : He will pay you 13,000 per year for next 15 yrs .
Choice 3 : He will pay you Rs 8,000 per year for whole life .
Which one should you choose ?
Here you have to take a decision of choosing from one of the choices . The logical decision here will be to go for choice whose Net Present Value is Highest . You have to understand the time value of money . Rs 10,000 received today is much more valuable than Rs 10,000 received 10 yrs later, even Rs 15,000 received after 10 yrs .
So you have to see that which choice has the highest worth if you calculate its Value today .
So how do you calculate the Net Present Value in this case , where you have Rs X receivable every year for n years . Here you also have to consider present rate of returns which you can assume at 8% .
So We have 3 variables
X : Amount received per year
n : Number of years
r : Present rate of return
NPV = X * [(1+r)^n – 1]/[r * (1+r)^n]
Calculating through this formula , we get the NPV of the choices as
Net Present Value of the last choice is simple , how much money do you put in bank today that will fetch you 8,000 per year forever ? If X is the amount than at 8% interest you get 8,000 , so
8% of X = 8,000
.08 * X = 8,000
X = 8,000 * (1/.08)
X = 1,00,000
If you see the total amount received in all the cases you will realise that the choices with lesser NPV will give you have higher Total amount .
For Case 1 : NPV = 120781 , Total amount received = 1,80,000
For Case 2 : NPV = 111273 , Total amount received = 1,95,000
For Case 3 : NPV = 100000 , Total amount received = Infinite (The amount is paid forever)
But you have to understand that “Total amount received” is not important . What can you do with the money is more important ? So the real Indicator is Net present Value of Money . You have to understand the Difference between Price Vs Value . Price is what you pay , Value is what you get . Value is important not Price .[ad#small-banner]
Real Estate Case
If you go for a home which cost Rs 50 Lacs @9% Interest for 20 yrs . Your EMI will be around 45,000 per month .
I found this amazing Apna Loan , EMI calculator , Its nice
You will actually pay total of 45,000 * 12 * 20 = Rs 1.08 Crores .
Now you may feel that the cost of house is Rs 50 Lacs ,but the amount outgo is actually 1.08 Crores and may feel bad for this , But this is ridiculous . Because you are not paying 1.08 worth of money in your entire tenure , 1.08 is just a number .
Its worth is still 50 lacs only spread over 20 years and the numbers sum up to 1.08 crores .
If you calculate NPV of the Home loan money which you are paying , its exactly 50 Lacs . Calculate it with (.75% interest and 240 as tenure , as its a monthly and not yearly) .
Note : There can be other situations also where we need to calculate Net present value with a different formula , but for this post we are only discussing the examples and scenarios where you need to pay or receive a fixed amount after every fixed period for some tenure .
You can also look at Video below to learn other aspects of NPV and IRR (I have discussed it in the post : How to manage ULIPS ?
You can also use this concept for taking decisions in scenarios where you have different choices of payments , choose the one which has lowest Net Present Value , like in the example we took , For the friends its more beneficial to go for the 3rd option . So the moral of the story is that dont pass this post link to your friends with whom you have financial relations 🙂
Should Banks state net present Value of the money customers pay as loan , so that people come to know that they are getting fair value for there money ?
Read interesting note on Home Loan EMI , Read how Home Loan EMI is Calculated ?
Readers , are you getting a horizontal scroll bar when you view this blog ? If its irritating for many people I will fix it ? It depends on your computer resolution how does it look to you , for me , it works fine .
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