There is nothing new about this idea. For example, at Harvard Law School, they teach Negotiation skills and it is all about BATNA (Best Alternative To a Negotiated Agreement). It is used in Mid-East Peace Talk, company M&A, etc.
We already did this in previous sections. When we look at what to take for a lottery win or our little Christmass Tree business, we basically compare cash flow and NPV from two options, and decide which one is the better option.
One more example : at certain point time of our life, we will decide whether to rent or buy a house. Let's first list the cash flow of each option.
Option A : to rent
Positive cash flow : you will invest the 20% down payment (see below) at a mutual fund which get 5% return of investment;
Negative cash flow : monthly rent, which would increase over time (which is either stated in rental contract or, if not, with certain assumption such as inflation rate or historical data). Let's assume it is $2700 per month rent for a $800K house.
Option B : to buy
Positive cash flow :
-- annual tax refund from mortgage interest rate
-- assume you will sell the house, say, 10 years down the road, you could get a potential profit from it. It is the selling price minus the remaining mortgage principle (and minus the fee for the realtor). The selling price can be estimated from historical data, from e.g. www,zillow.com.
Negative cash flow :
-- one time mortgage application fee & points. For simplicity, assume you got a no-point/no-fee mortgage. So, you simply got a $800K mortgage
-- one time downpayment (say 20% down of the $800K)
-- monthly mortgage payment, at certain APR (say 5%)
-- annual property tax (say 1% of the value of the property)
-- annual house insurance (say $800 USD)
-- annual house maintainance and fix-up cost (say $1000)
Now, your homework is to figure out which option represents better NPV. Your hope for Option B to come out better is if you make good profit when you sell your house.
After you figure out NPV of Option A vs. B, let's do some sensitivity analysis. For example, if your monthly rent changes from $2700 per month to $3000 per month, how it would affect your decision ? Do this for all the critical factors. Now you have a pretty good idea about what you are facing.
