Two friends A and B were sitting under a tree and engrossed in some discussion.
They had a problem on hand.
A’s father had agreed to pay him Rs 1 Cr. to help him settle in life But B’s father had made another arrangement. Not sure of B’s maturity, he was promised Rs 1.2 Cr after 3 years.
B was showing off his offer to A saying that his father had given a much better deal.
However, A not ready to give up argued that his deal was better because he was getting paid immediately.
Now this argument went on for several hours till it was evening.
However, this problem was just not getting resolved.
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 stopped their argument.
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 B had been promised after 3 years.
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.
Therefore, the value of Rs 1.2 Crores after 3 years needs to be discounted by an assumed rate of inflation. Let us say the rate of inflation we assume is 8%per annum!
The formula for calculating the net present value or
NPV = Amount / (1+R) ^n
where Amount is the Rs 1.2 Cr that B would get after 3 years.
“R” is the rate of assumed inflation and “n” stands for a 3-year period.
So, using the formula we get
NPV = 1.2/ (1+.08) ^3 = 1.2/ (1.08) ^3 = Rs 95 lakhs
Thus, I told B that the net present value of the money promised to him is Rs. 95 lakhs and hence it less than what A is receiving.
I thus told them that one should simply not get blindly excited by the 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.
