IRR FAQ - Frequently Asked Questions on Internal Rate of Return

Question: Please advise how to calcuALTe the NPV and PV of an amount with interest rate say 6% and inflation rate of 2.5% over a 20 years period. In other words how to incorporate the inflation rate in the PV and NPV formulae.

Answer: Assuming that you put \$100 in the bank. And the bank pays you an interest of 6%. If you do not withdraw the amount (\$106) at the end of 1 year, the bank will pay you interest of 6% on your \$106, i.e. \$112.36. If this continues for 20 years, you would have \$320.7135472 in the bank. This is called the future value of \$100 at the end of 20 years. To factor in inflation, discount the amount (\$320.7135472) by 2.5% (inflation rate). You will get \$195.72. That is the present value of \$320.7135472. This means that you could buy \$195.72 of good and services (non perishable) today and keep them for 20 years, they will be worth \$320.7135472 in 20 years time. Deduct the present value (\$195.72) from the amount you put in (\$100) and you get \$95.72. That is Net Present Value, the returns for putting \$100 in the bank.