To calculate net present value of an investment, divide the guaranteed return by 1 plus the interest rate that a different investment would bring in, and subtract the initial investment from the result. Consider a positive answer a sign that the investment is comparatively sound.
- Determine the return of two investment scenarios
Consider the example of a coworker asking to borrow $1,000 now, promising to pay you $1,250 after a year. Balance that against the chance to earn 8 percent by investing in a private mortgage fund.
- Find the present value by comparing the two investments
Divide the return your friend promises by 1 plus the interest rate from the mortgage fund, written in decimal form: 1,250/1.08. Divide to find the answer, which is $1,157.41.
- Subtract your initial investment to calculate net present value
Take $1,157.41 and subtract the $1,000 you initially invested, for a difference of $157.41. Interpret the positive answer to mean that lending money to your friend is $157.41 better than investing money in the private mortgage fund. Compare this to a scenario in which you could earn 28 percent through a third investment. Divide 1,250 by 1.28 to get the new present value, which is $976.56. Subtract the initial $1,000 for a result of -23.44. Consider the implications of lending to your friend, which is now $23.44 worse than the third investment opportunity.