“A car with a small hole in its fuel tank unattended to shall see its fuel draining little by little and it shall only be left in the middle of a long journey! So is life! Mind the small things!”

― Ernest Agyemang Yeboah

In one of the previous posts, we discussed about the importance of Net Present value (NPV) for deciding the financial viability of any project. For readers who have not gone through that post, the link is provided below.

https://theunruffledman.blogspot.com/2022/11/payback-does-it-truly-pay-off.html

You can visit the above post for a quick grasp of the concept. In a nutshell, NPV, which is also known as the discounted cash flow method, takes time value of money into account. The value of a project's returns in the future won't be the same as it is today. In other words, if the enterprise generates a $100,000 return after a year, its worth will be lower than it is now. With $100,000 today, you can buy more things than you can in a year, means, the returns are discounted. NPV considers the future returns of the project at the present market value. The project is financially viable if the total of all future value returns at the current market value exceeds the initial investment.

When deciding whether to replace the outdated machines that were still in use, my organisation only used the Payback period method of calculation to determine the financial viability. The NPV idea was a huge hit when I first introduced it. The Payback approach had previously designated a number of machines for scrapping; however, NPV proved that replacing them would not be cost-effective, therefore these equipment were later put back into service. Only completely broken machines were replaced.

It's interesting that this NPV method can be applied to a wide range of other situations where we must make a financial choice. We will talk about how to decide whether to buy a house or rent one in this post.

Imagine the following scenario.

You have to take a decision whether to buy or rent an apartment house for your family.

You have the following data.

DATA
COST OF APARTMENT	=	5000000	INR
LOAN ELIGIBLE FOR	=	4000000	INR
LOAN TENURE	=	15	YRS
EMI PER MONTH	=	47783	INR
EMI PER ANNUM	=	573396	INR
HOUSE RENT SAVED PER MONTH	=	20000	INR
HOUSE RENT SAVED PER ANNUM	=	240000	INR	INCREASES 10% EVERY 2 YRS
PROPERTY TAX PER ANNUM	=	7500	INR	INCREASES 20% EVERY 10 YRS
ANNUAL REPAIR COST FOR 1ST 10 YRS	=	24000	INR	INCREASES 50% EVERY 10 YRS
BANK INTEREST RATE	=	8	%
DISPOSAL SALE AFTER	=	20	YRS
DISPOSAL VALUE AFTER MAJOR REPAIRS	=	15000000	INR

The above table shows the EMI which will be 47783 INR per month over a period of 15 years at an interest rate on 8%. This is a cash outflow. Cash outflows also include the annual repair costs and property taxes that must be paid. According to the displayed data, the cost of repairs and the property tax are not constant over the course of 20 years, but rather alter with time.

A house rent of 240000 INR per year, which grows by 10% every two years, will be saved if the house is purchased. This is a cash inflow. The income tax savings you obtain on your home loan interest payments are not depicted in the table above. If you live in India and pay 30% of your income in taxes, you would save 30% of the interest you would have paid. However, there is a 2,000,000 INR cap on the interest rate.

So, you have the list of periodical payments you have to make and the list of periodical returns you will receive, over 20 years. The loan will be closed after 15 years. The house will be used for 5 more years and sold out.

How should the financials be calculated now? We will work out the solution.

We are aware that the bank won't cover all of the costs. We must use funds from our savings to pay the builder's initial down payment, registration fees, and other charges. This is not funded by banks. The following table lists this initial investment.

DOWN PAYMENT TOWARDS PURCHASE OF APARTMENT

Every year there is an outflow of money in the form of EMI, Property taxes and Repair cost etc. Similarly, there is an inflow of money in the form of Rent saved and Income tax saved. You can tabulate the outflow and the inflow as shown below.

We now have distinct year-wise outflow and inflow figures. The net flow on a yearly basis is calculated by deducting the outflow from the inflow and is shown in the table below.

The net flow is negative for the first 15 years, as can be seen from the table above and the chart below. By the way, the debt is paid off after 15 years. Since the sixteenth year, there has been positive netflow. Keep in mind that they are future returns, whose present value is always lower.

Let's now calculate the present value.

PRESENT VALUE

The overall present value returns come to 1755839 Indian rupees. The table above also displays the home's sale price. The used home might sell for 15000000 INR after 20 years. Since the building would have been in operation for 20 years, it might appear that the sale price is unusually high. However, according to the preceding table, this 15000000 INR's present value is only 3218223 INR.

The previous paragraphs indicated the starting investment amount, which is 1565000 Indian rupees. The previous table provided the entire present value of returns, which came to 1755839 Indian rupees. If the present value of future returns is greater than the initial investment, buying a home makes sense. The term for this is "Net Present Value (NPV)"

Here, the NPV = Present value returns (1755839) – Initial investment (1565000) = 190839 INR

The NPV is a positive figure. So the Project is financially viable. The home can be bought.

For the same example, if the interest rate is increased from 8% to 10 %, (OR) if the loan duration is reduced from 15 years to 10 years (OR) if the sale value of the house is reduced from 15000000 INR to 14000000 INR, then NPV turns negative, which means your proposal is to be dropped.

The NPV only conveys financial viability; it does not account for the worth of the intangible physical labour expended to acquire your home. You will need to visit the project site, banks, the registration office, the attorney's office, etc. on numerous occasions.

Regardless, NPV is quite helpful, isn't it? You can calculate for all permutations and combinations with just one Excel file. The net returns in the above example has been represented graphically below, which shows the importance of today's value of tomorrow's money.