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.
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