Q:

How do you calculate NPV?

A:

Quick Answer

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.

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Full Answer

  1. 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.

  2. 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.

  3. 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.

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