MBA Class; Use Net Present Value to Make Investment Decisions

By in Advanced Investing, Asset Allocation, Investing, Mutual Funds, Retirement | 15 comments

Investing Solutions (part 3)

Welcome to Investing Solutions Week at Barbara Friedberg Personal Finance. Don’t miss parts 1 and 2.

I’m in the midst of teaching a Corporate Finance class for MBA students at a local university. Some of the concepts, although rather complicated, have important real world applicability. an extremely important concept is, how to use net present value (NPV). It 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.

Use net present value to decide between a lump sum payment or an annuity.

 

 When reading one of my favorite blogs, Consumerism Commentary, Luke had to decide whether to take a lump sum payment of his retirement account or monthly payments for the rest of his life. After reading the article, I was curious about which choice would lead to a greater present value for Luke. Here’s 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.

Before I tell you which one he chose as well as the alternative most of his readers recommended, I’m going to introduce you to a systematic way to decide whether to take a lump sum payment or an annuity.

Read more: Should I Invest in an Annuity?>>>

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 historically, an investment portfolio containing about 65% stocks and 35% bonds approximates a 7% return. 

To calculate how much a regular payment which continues indefinitely is worth today, all you need is this 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.

Use Net Present Value to decide-Annuity or Lump Sum Payment?

Did Luke Choose a Lump Sum Payment or the Annuity?

Luke is a smart guy, as are his readers. And guess what, he took the $18,000 lump sum payment. And most of his readers also recommended that alternative.

Now all he has to do is invest that money in a few diversified index funds and watch it grow.

Click here to learn more about the best way to invest, so that your money will grow and compound.

Don’t miss the first two Investing Solutions articles:

My work was showcased at these sites:

Which alternative would you choose, and why?

A version of this article was previously published.

    15 Comments

  1. Thanks for the mention! And I think Flexo did the right thing, take the lump sum. Now he needs to invest it. 😉

    Little House

    February 26, 2011

  2. Hi Little House, Actually, I think he’s saving for a house, just like you 🙂

    Barb

    February 26, 2011

  3. Such a simple calculation for making the decision. Also nice series you wrote. I keep saying this money stuff is easy to understand. But people just don’t follow through and do it.

    Dave@50plusfinance

    February 27, 2011

  4. @JT-Very nice suggestion. And for those folks even lazier, there a lots of on-line caculators as well!
    @Dave-DAve, my thoughts exactly, I’d like to take on a campaign to increase finanial literacy. Are you in?

    Barb

    February 27, 2011

  5. A simple answer for an important issue. Too often, we make bad decisions because of ignorance or laziness. In this case thousands of dollars were at stake.

    krantcents

    February 28, 2011

  6. @Krantcents-It’s fascinating how lack of knowledge and planning leads to a poor financial outcome! Feel free to pass the example along.

    Barb

    February 28, 2011

  7. I’m not sure I agree with these calculations; depending on Flexo’s life expectancy, at some point the lifetime payout will exceed the value of the lump sum. Consider insurance companies that sell Annuities: A lifetime annuity that pays $780 per year will have a different cost for a 20-year-old (16,361.28) than for a 70-year-old ($9,242.69).

    HDL-NYC

    May 27, 2011

  8. HDL-I understand your point. But, for example if Flexo took the $65 per month, he would reach $18,000 in 23 years. The formulas take into consideration the “time value of money” theory which purports that considering inflation and uncertain rate of return, $1 today is worth more than $1 next year. Thanks for your input.

    Barb

    May 30, 2011

  9. Hi Barbara,

    Simple yet powerful post about present values.

    Will the value be higher if this was compounded on a quarterly or monthly basis?

    Thanks

    Meiko

    Meiko

    March 8, 2012

    • Hi Meiko, More frequent compounding yields higher returns, all other things being equal.

      Barb

      March 8, 2012

  10. Your example is pretty straight forward and easy enough to follow. Lets complicate it a bit.

    Lets say my investment decision is the purchase of real estate – a more common occurrence than winning the lottery.

    I know that the net income from the property I’m considering buying after expenses is $223,000 per year. The seller is asking $2.4 million. I want to give the seller 3 to 5 offers from which to choose. The most I can offer is a 5% down payment and would like the seller to finance 95%. Some of my variables/negotiating points include:

    1) interest rate
    2) amortization period
    3) payments: interest only, principal only, principal & interest
    4)length of loan such as 3 years, 7 years, 10 years, 15 years

    How can I structure some offers that end up being the same return to me as the buyer, but give the seller different choices?

    For example, say I offered I% interest only for N years amortized over Y years. What interest rate and term can I offer for an equivalent P&I payment and/or principal only payment, so that my return remains constant? How do I set this up? Am I even asking the right question? How exactly do I present several different offers without making a loser out of myself (or the seller)?

    Thank you

    Dude

    April 10, 2013

  11. Hi Dude, I’ve been in the real estate and portfolio management field for decades. I have never encountered offering the seller more than 1 offer at a time. If you are interested in various options, I would advise asking the seller (or having your agent do so)which they would prefer. The return to you will not be the same if your payment varies unless you adjust your down payment. Your real estate agent should be able to assist with these questions as well.

    Barb

    April 10, 2013

  12. Sorry, I didn’t mean I would be offering them to the seller but want to choose among my various options and then select the best scenario to offer the seller.

    Dude

    April 12, 2013

  13. Hi Dude, Realtor.com has some excellent calculators to answer these questions ( http://www.realtor.com/home-finance/financial-calculators/ ). Input the various scenarios in order to choose among your alternatives. The “mortgage calculator” and “loan comparison by term” seem like the most useful for you.

    Best of luck, Barb

    Barb

    April 13, 2013

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