Net Present Value
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The document discusses the concept of net present value using an example of two friends, Shekhu and Pheku, arguing over which offer from their fathers is better. Shekhu is offered Rs. 1 cr immediately while Pheku is offered Rs. 1.2 cr after 3 years. To compare the offers, the document explains how to calculate the net present value of Pheku's future cash flow of Rs. 1.2 cr after 3 years by discounting it using an assumed annual inflation rate of 8%. Using the net present value formula, the document calculates Pheku's offer has a present value of Rs. 95 lacs, which is less than Shekhu's immediate offer of Rs. 1 cr. Therefore,
Net Present Value
- 1. Understanding what is “net present value of money” TM – By Prof. Simply Simple Two friends Shekhu and Pheku were sitting under a tree and engrossed in some discussion
- 2. They had a problem on hand
- 3. Sheku’s father had agreed to pay him Rs 1 cr. to help him settle in life But Pheku’s father had made another arrangement. Not sure of Pheku’s maturity, he promised Rs 1.2 cr after 3 years
- 4. Pheku was showing off his offer to Sheku saying that his father has given a much better deal. However Sheku not ready to give up argued that his deal was better because he was getting paid immeditely. Now this argument went on for several hours till it was evening. However this problem was just not getting resolved
- 5. This argument was taking place just in front of my office. Seeing these guys’ argument stretch across the entire day, I got curious and walked up to them to understand their problem. When they explained their positions, I offered to intervene provided they stop their argument.
- 6. I told them that in order to compare their situations it would be necessary to find out the net present value of the Rs 1.2 cr that Pheku had been promised after 3 years.
- 7. Here it is important to understand that the purchasing power of money reduces almost every day due to the rise in price of goods and services due to inflation.
- 8. Therefore the value of Rs 1.2 crores after 3 years needs to be discounted by an assumed rate of inflation. Let’s say the rate of inflation we assume is 8%per annum
- 9. The formula for calculating the net present value or NPV = Amount/(1+R)^n where Amount is the Rs 1.2 cr that Pheku would get after 3 years. “R” is the rate of assumed inflation and “n” stands for 3 year period
- 10. So using the formula we get NPV = 1.2/(1+.08)^3 = 1.2/(1.08)^3 = Rs 95 lacs
- 11. Thus I told Pheku that the net present value of the money promised to him is Rs 95 lacs and hence it less than what Sheku is receiving.
- 12. I thus told them that one should simply not get blindly excited by an amount being offered in the future. Inflation is our constant companion and hence it is imperative to calculate the present value of all future cash flows for comparison
- 13. Hope this lesson has succeeded in clarifying the concept of “net present value” Please give me your feedback at [email protected]
- 14. Disclaimer The views expressed in these lessons are for information purposes only and do not construe to be of any investment, legal or taxation advice. The contents are topical in nature & held true at the time of creation of the lesson. They are not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at your own risk and Tata Asset Management Ltd. will not be liable for the consequences of any such action.