MBA Class; Use Net Present Value to Make Investment Decisions

By in Advanced Investing, Asset Allocation, Investing, Mutual Funds, Retirement

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:

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Which alternative would you choose, and why?

A version of this article was previously published.