How to Calculate Net Present Value (NPV) and how to use it

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 .

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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

1. 120781

2. 111273

3. 100000

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)

Calculate NPV for your self , see this calculator

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 .

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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 ?

Conclusion :

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 :)

Questions ?

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 ?

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By Manish Chauhan on May 7, 2009 · Posted in Other Products and Concepts

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10 Comments | Post Comment

sachin says:

I have query with regards to home loan.
The banks are calculating rate or interest = PLR + Sread
Now PLR is defiend by RBI…can banks have the PLR which is of much higer value than defined by RBI…

Posted on December 4th, 2009

manish says:

yes .. Bank have their own PLR which tracks the PLR befined by RBI , when RBI decreases the rate , Public banks generally also lower their PLR soon , but Pvt banks do not do it fast .

Manish

Posted on December 4th, 2009

Review of Jeevan Tarang Policy from LIC says:

[...] Money Back : After 3 yrs of completion , the Policy acquires a Surrender value , generally its the Net Present Value of money in todays term what you are going to get at the end . See this post on Net Asset Value . So if you [...]

Posted on December 11th, 2009

Ken says:

Hi,

How much should I save monthly for the next 5 years so that I get a sum of Rs.15 lacs on the 61st month? is there a simple formula to reverse calculate?

Thanks in advance!

Posted on March 2nd, 2010

Manish Chauhan says:

Ken , you should look at http://www.jagoinvestor.com/2008/09/3-most-important-formulas-you-should.html and try to put a particular “r” for which your equation satisfies .

Manish

Posted on March 2nd, 2010

How Inflation Eats Your Savings | PUC & B.Com says:

[...] keep value of you money same , theĀ absolute return earned must be greater then [...]

Posted on June 21st, 2011

Yash Dubey says:

An eyeOpener for many, head opener for some..

Calculations made simple..

Posted on January 8th, 2012

Manish Chauhan says:

Thanks Yash

Manish

Posted on January 9th, 2012

Shobaan says:

Hi Manish,

great insights. I would like to invest for my son’s educational needs, he is 5. As per the NPV eg stated by you, it looks like we should invest a lesser premium amount for a longer term holds the key to reap benefits? Please correct my understanding!

Posted on December 6th, 2013

Manish Chauhan says:

Yes, you need to invest for long term

Posted on December 12th, 2013