Lisa has this query:
My friend Jenny wants to do her two year graduation course. She is 28. She also has a job offer that would earn her $55,000 per year and grow 3% annually. However, with a graduate degree in her hand she can expect to earn $85,000 per year with a 3% annual growth. She plans to work until 60. If she decides to do her graduation she will have to pay $40000 as tuition fees immediately. Her second year fees, payable at the beginning of the year, is estimated to be $42000. She will also incur living expenses of $8000 in the first year which will increase to $9000 next year. She will earn $18000 at the end of the first year from an internship. She is confused and wants to know what she should do? Hint: If the interest/discount rate is 6%, what is the NPV of her graduate education. Note: All cash flows except tuition fees occur at the end of the year.
What is NPV or Net Present Value?
As described earlier also the Net Present Value or NPV calculates the value of an investment, project or idea today by using an interest or discount rate and a series of future payments (negative amounts) and future income (positive incoming amounts). When you start a project you use effort or make an investment. All future incomes are reduced to the present day values using a discount rate usually defined by market forces like bank interest rates and then added. Now you add the value of your starting investment which is a negative cash flow because you are ‘spending’ it. Given below is an example of a calculation of NPV in Excel. The value you get is in $ terms. The higher the positive NPV, the project is considered superior to similar projects.
Based on this basic information we can proceed to understand whether Jenny should pursue her graduation.
Watch the video below to learn how to use NPV or Net Present Value as a decision making tool with the help of MS Excel:
Calculating Net Present Value