Real World Applications of NPV

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From the course by University of California, Irvine

The Power of Microeconomics: Economic Principles in the Real World

827 ratings

University of California, Irvine

The Power of Microeconomics: Economic Principles in the Real World

827 ratings

In this course, you will learn all of the major principles of microeconomics normally taught in a quarter or semester course to college undergraduates or MBA students. Perhaps more importantly, you will also learn how to apply these principles to a wide variety of real world situations in both your personal and professional lives. In this way, the Power of Microeconomics will help you prosper in an increasingly competitive environment. Note that this course is a companion to the Power of Macroeconomics. If you take both courses, you will learn all of the major principles normally taught in a year-long introductory economics college course.

From the lesson

The Capital Market, Interest, and Profits

Capital Analysis in the Real World; Three Categories of Capital Goods; Interest Rate Defined; Rate of Return 7:37

Depreciation; Theory of Loanable Funds; Two Interest Rate Functions 5:46

How Shifts in Demand and Supply Affect Interest Rates; Investment Analysis Over Time; Net Present Value; Perpetuities6:48

NPV In the Real World; NPV Equation 4:11

Real World Applications of NPV 4:39

Interest Rates In The Real World; Factors Determining Interest Rates 3:24

Meet the Instructors

Dr. Peter Navarro
Professor
Paul Merage School of Business

[MUSIC]

Now let me show you how you can use these same formulas to solve

several of the real world puzzles I posed to you in our very first lecture.

Remember the refrigerator problem?

In that problem, you have a choice between a new energy

efficient refrigerator which costs $750 or the cheaper model at $500.

If you buy the energy efficient refrigerator, your electricity

bill will be $120 a year cheaper over the five-year life of the refrigerator.

Assuming an interest rate of 8%, which refrigerator should you buy?

Assuming of course, that you'll make your choice purely on

economic grounds, rather than upon any possible concern about saving energy.

Here again is the math.

The next present value of the investment

is calculated by first subtracting the purchase

price of the cheaper refrigerator from the

purchase price of the more expensive refrigerator.

To get the net additional investment required to buy the more expensive model.

This is $250 which we put a minus sign

in front of because it is an investment outlay.

Then we simply

calculate the time value of the savings, which turns out to be $479.

Subtracting $250 from this, yields a positive NPV of $229.

Clearly the seemingly more expensive refrigerator turns out

to actually be cheaper from net present value perspective.

Now how about an investment in a different kind of capital.

Your own human capital.

To illustrate this, lets recall the dilemma

of Priscilla and Phil from our first lecture.

As a family they are trying to decide whether Phil should quit

his job in order to enter a two year program for his MBA.

Phil's situation is this, he's 45 years old and

his making good money at his job as a salesman

at a medical equipment company, $50,000 a year.

Nonetheless, Phil feels stuck in his job, knowing that he can

never advance further in his company or his career without additional education.

However, with an MBA degree, Phil could move into the corporate side of the

company and make at least $85,000 a year, right up until retirement at age 55.

Unfortunately, the MBA program he wants to enroll in will cost him $80,000.

$40,000 a year, and he will have to borrow money to do it, as well as quit his job.

Fortunately, Priscilla brings home a decent salary, one big enough to

support Phil and their two children over the next two years.

So the only question they have is whether it makes financial sense for Phil to

take this major step. So what should Priscilla and Phil do,

assuming an interest rate of 6%? OK, here's the numbers.

Did you remember to count Phil's foregone salary

as an opportunity cost of entering the program?

That's $50,000 per year for two years.

And that plus the $40,000

tuition for two years gives an annual cost

of Phil's investment in human capital of $90,000.

Properly discounting this sum at a 6% interest rate over the two-year period

yields a net investment cost of $165,903 in Net Present Value terms.

Now, let's look at the other side of the investment coin.

Phil's incremental income from getting his MBA will be $35,000 per

year, which is the difference between his current and future salary.

However, his new salary won't start until year three.

Properly discounting this income flow through year

ten, when Phil reaches retirement, yields $193,434.

So, what's the NPV of

Phil and Priscilla's investment?

That's right, it's positive $27,531, which is simply the difference

between the NPV of the investment outlay and the NPV of the income stream.

So Phil should go get his MBA.

But, would that still be the case if interest rates were 12%?

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