How Do You Calculate NPV?

# How Do You Calculate NPV?

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.

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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