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How Net Present Value (NPV) Can Help You Make Smarter Financial Decisions

This article explains the concept of NPV - a financial tool that helps you compare investment options to use in buying insurance, SGB and in many other cases.

How Net Present Value (NPV) Can Help You Make Smarter Financial Decisions


Posted on 20 Aug 2023
Author: Sayan Sircar
7 mins read
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This article explains the concept of NPV - a financial tool that helps you compare investment options to use in buying insurance, SGB and in many other cases.

How Net Present Value (NPV) Can Help You Make Smarter Financial Decisions

📚 Topics covered:

Introduction

Net Present Value (NPV) is a finance concept that will change how you decide between different financial decisions like:

  • choosing between two houses for a long-term lease
  • which SGB should you buy from the secondary market
  • should prepay your home loan or invest any surplus cash
  • should you buy Term insurance with return of premium option: Term Insurance with Return of Premium: a Complete Waste of Money
  • if you have multiple loans, which one should you pay off first
  • should you pay your term insurance policy fast or at normal speed
  • should you take a shorter or longer duration loan for buying a car
  • is an endowment or whole life policy is worth the premiums being paid

We will cover the concept of NPV in this article and then cover the above use cases one by one in a future article(s).

What is Net Present Value (NPV)?

To understand NPV, we need to understand two concepts:

Present value of a cashflow (PV)

A cashflow is money spent or received sometime in the future. Some examples can be:

  • EMI payments on a home loan
  • money received as bonus payment in Diwali
  • down-payment for a house five years for now
  • salary or rental income received every month
  • interest received every six months from a government bond or SGB

The present value (PV) of any future cashflow is what you will be willing to accept today instead of receiving the same cashflow in the future.

For example, if you are expecting to receive ₹10,000 from a friend a year from now, you would also be willing to receive ₹9500 from that same friend today if you keep that ₹9500 in an FD today that gives interest of ₹500 in one year. Here PV of the ₹10,000 cashflow due in one year is ₹9500 discounted at a rate of 10000/9500 -1 = 5.2%. To understand more about this concept of discounting to the present, we need to understand the next concept.

Time value of Money (TVM)

Time Value of Money simply says that money is worth more today than in the future. The simplest reason is that we can keep money in a risk-free SBI FD and get more money in the future. Conversely, receiving ₹10,000 today is better than receiving ₹10,000 a year from now. Since prices of things go up with time due to inflation, the ₹10,000 received in the future will be worth less in the future than today. We will quickly cover two examples of TVM:

  • receiving 1 lakh every year for 10 years starting 10 years from now is worse than receiving the same 1 lakh every year for 10 years starting 5 years from now. This means that you cannot add up cashflows occurring at different points of time (both are 10 lakhs) to compare them. We see such examples in the case of insurance policies with payments in the future
  • paying less total money today for a short time (say ₹10,000/year for 10 years), vs paying more total money over a longer time (₹5,000/year for 30 years). This is the example of accelerated premium plans in the case of insurance policies vs. normal payment

The rate at which we will value future money vs. the money in hand today is the discount rate.

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How does NPV work?

NPV Application In Real Life

To calculate NPV, we calculate the future cashflows first, discount them to the present, add them and subtract the amount of money we are paying today. NPV does not have any utility by itself but is instead used to compare two or more financial products. Let us take one case study of purchasing a single premium insurance:

  • Option 1: pay ₹5 lakh today and get ₹1 lakh/year from years 6 to 15 (i.e. a total of ₹10 lakhs)
  • Option 2: pay ₹5 lakh today and get ₹2 lakh/year from years 11 to 15 (i.e. a total of ₹10 lakhs once more)

We will assume a discounting rate of 6%, say that of a FD or debt mutual fund.

The NPV calculation is shown below:

For option 1

Year Cashflow (lakhs) PV (lakhs)
0 -5 -5.00
1   0.00
2   0.00
3   0.00
4   0.00
5   0.00
6 1 0.70
7 1 0.67
8 1 0.63
9 1 0.59
10 1 0.56
11 1 0.53
12 1 0.50
13 1 0.47
14 1 0.44
15 1 0.42
NPV - ₹2.23

For option 2

Year Cashflow (lakhs) PV (lakhs)
0 -5 -5.00
1   0.00
2   0.00
3   0.00
4   0.00
5   0.00
6   0.00
7   0.00
8   0.00
9   0.00
10   0.00
11 2 1.05
12 2 0.99
13 2 0.94
14 2 0.88
15 2 0.83
NPV - ₹3.23

Here option 2 is a better choice between the two since the NPV is higher. The keyword here is between the two. There might be other better investment options with better NPVs.

Readers should note that in both cases the insurance company is paying the same notional amount of money (₹10 lakhs) but since they occur at different time periods, the present values are different.

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This post titled How Net Present Value (NPV) Can Help You Make Smarter Financial Decisions first appeared on 20 Aug 2023 at https://arthgyaan.com


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