Real Life Net Present Value (NPV) Example
While teaching a Corporate Finance class for MBA students at a local university, I was asked a question that underscored importance of the net present value concept. Although NPV might be considered a panacea, there are definitely some pros and cons.
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Net present value is a method to put a dollar amount on future cash payments. It’s great if you win the lottery and want to determine whether to choose the lump sum payment or monthly option. Or what if you or your folks want to determine the present value of their monthly social security or annuity checks.
Sounds great, but there are very real pros and cons of net present value.
This net present value example underscores the real life applicability of NPV.
Real Life Net Present Value Example
Luke had to decide whether to take a lump sum payment of his retirement account or monthly payments for the rest of his life. This problem is more common than you might imagine. Although you’ll need to make this decision if you win the lottery. You’ll also need to decide between a lump sum payment or an annuity when you withdraw funds from certain retirement accounts.
Here’s a real NPV example about how to use net present value to decide whether a lump sum or annuity payment would be worth more.
Here was Lukes’s situation:
He could receive a lump sum payment of $18,000 or $65 per month for the rest of his life.
How to Calculate and Understand Net Present Value
You need to make an assumption before figuring out which alternative is better. The assumption is this; what percent return do you think you can get on your investment? I chose 7% because given historical stock and bond market returns, this seems like a reasonable rate of return for the future.
To calculate how much a regular payment which continues indefinitely is worth today, all you need is this NPV perpetuity formula:
Annual cash flow/Interest rate = Present Value
If Luke were to receive $65 per month, then he gets $65 x 12 or $780 per year.
Take the $780 and divide it by the 7% interest rate: $780/7%=$11,142.86
Thus, if you assume that Luke can receive an average annual return of 7% then the net present value of his $65 monthly payment is worth $11,142.86 today.
So which is worth more today, $18,000 or $11,142.86? Since he was offered $18,000 or the $65 per month, he should take the $18,000, because it is worth lots more than the net present value of the $65 per month or $11,142.86.
Luke’s example was relatively clear cut. It’s likely that he could invest the $18,000 today and earn an average 7% return going forward. That would give him a cash flow of $1,260 per year, $480 more per year than the annual $780 ($65 per month) offer. Or, if he chose to reinvest that money, his money would compound exponentially.
Net Present Value Advantages and Disadvantages
This was a relatively easy case, because the lump sum payment was relatively larger than the monthly annuity. Where this NPV example gets complicated is when we change the inputs or future returns are difficult to project.
Pros
Takes ino acount the premise that a dollar today is worth more than a dollar at a future date.
If cash flows are guaranteed, and you can accurately predict your discount rate, or future interest rate, then the NPV calculation is an accurate comparison metric for the lump sum versus annuity payment.
Even if the cash flows have a limited time and are not “forever”, you can use a net present value online calculator to financial decisions.
NPV is a useful calculation to determine the profitability of an investment.
Cons
If the interest rate or discount rate is inaccurate, then the investment decision might also be inaccurate.
In reality, it is difficult to predict long term interest rate or cost of capital. In the short term, it is an easier task. So the NPV calculation is less accurate for longer term projects and investments.
NPV ignores other costs that may be involved in the decision, that would impact the results.
Related
Should I Invest in an Annuity?
The Financial Planning Process
Is Money the Only Measure of Success?
Values and Money – Are Yours Money-Makers or Money Losers?
