This is a question in an online finance lesson, and I know what they want for the answer. But I'm not at all a novice at financial matters, so in my mind, I would do this differently.
The question is an example for calculating Net Present Value:
You are considering buying out your boss when he retires at year end. You will need to put up 100k at that time, and your profits will be 20k per year. If your goal is a 6% annual return for 8 years, should you do it?
They want you to calculate the Present Value of the inflows with the 6% return (124,196), and compare with PV of outflow (100k) and draw the conclusion that yes, you should go ahead because NPV is positive.
But in my mind the 6% desired return applies to the 100k initial investment, and not the inflows.
- So I would calculate Future Value of that, i.e. in 8 years, if the business in fact returned 6% annually, I should have $159,384.81.
- Then I would ask, ok, will the 20k per year inflows achieve that desired outcome? This would again be a future value calc, not a present value one. Assuming the 6% can be used again for this part, that would be $197,949.36
- Even with 0%, the FV of the cash inflows would be 160k
So again, yes, the investment would meet the objective. But my intuitive approach is very different than that from the example.
Am I wrong? Why?