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Student Question of the Week: Net Present Value Calculation

Student Question from Greg C
Course:  Fundamentals of Financial Planning

Student Question:

Hello! It seems to me that the loan proceeds in Question 3 should be positive cash flow entries in year zero, especially if their repayments are negative CFs in Year 5. Why is this not so?  Thanks – Greg

Question 3:

Donald buys small houses at foreclosure which he then rents out, planning to sell them in five years. Two houses are currently available to him. House #1 would require a $20,000 down payment and an $80,000 interest-only loan (i.e., whenever he decides to pay off the loan, the principal balance will always be $80,000). House #2 would require a $45,000 down payment and a $105,000 interest-only loan. He estimates the cash flows would be:

Year House #1 House #2
1 $-1,000 $1,500
2 1,000 1,750
3 1,500 1,750
4 1,750 2,000
5 2,000 2,250

Donald estimates he will be able to sell House #1 for $200,000 at the end of five years and House #2 for $240,000. Based on the risks he is taking, Donald thinks he should get at least a 10% return on his investment. Which house should he buy? [Hint: Be sure to net your final cash flow, which includes the net income, plus the proceeds of the sale, less the payoff of the principal of the mortgage.]

  • House #1
  • House #2

Instructor Response:

Hi Greg!

Yours is a very logical question.  It’s confusing that we treat the loan proceeds as positive cash flow in a loan calculation but we do not in the NPV calculation.  In a “payment” calculation, we enter the loan proceeds as a positive present value.

In the NPV calculation, the loan proceeds are ignored in period 0 and are accounted for as a negative cash flow in the year of sale.  Here’s one way to view the NPV calculation.  The NPV calculation measures only ACTUAL cash flows from or to our checking account.

I hope that helps.  Let me know if not.

Bruce