POSTED BY May 7, 2009 COMMENTS (12)ON
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.
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]
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.
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.
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 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?
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