A business owner is in a dilemma. She is trying to decide if a new project for her business is a good idea. The venture will require $150,000 investment up front and will generate $50,000 per year in net cash flow (after expenses and taxes) for the next five years, after which the project ends with no salvage value and no further income. Should she jump on the opportunity or pass? Let’s look at some tools an entrepreneur can use to evaluate potential business projects to determine if they are worthwhile investments or uses of the company’s limited resources.
Evaluating Business Projects (before spending the money!)
By Kerry Woodson
A business owner is in a dilemma. She is trying to decide if a new project for her business is a good idea. The venture will require $150,000 investment up front and will generate $50,000 per year in net cash flow (after expenses and taxes) for the next five years, after which the project ends with no salvage value and no further income. Should she jump on the opportunity or pass? Let’s look at some tools an entrepreneur can use to evaluate potential business projects to determine if they are worthwhile investments or uses of the company’s limited resources.
One calculation many managers have used for years is a simple payback analysis. They would take the initial required investment and divide it by the annual or monthly cash flow and determine how long it takes them to get their money back. In our example, it would take 3 years to recoup the upfront cash outlay (150,000/50,000 = 3). Is this number an acceptable return and does it give a clear indication of the merit of the project? The short answer is that it depends on other factors and is what exposes the shortcoming of the payback calculation – it fails to take into account the time value of money and the cost of obtaining capital.
All money has costs associated with its use. These costs can be in the form of actual interest expense to lenders or dividends to investors. Even if it’s your own money, there is an opportunity cost because of the interest lost or by foregoing other investment options. For this reason, any endeavor should provide enough return to compensate for the use of money and any evaluation tool should include this facet in order to give a true picture of the relative merits of the proposed venture. The concept of net present value provides a great way to accomplish these goals.
Simply stated, net present value (NPV) is the difference between the present value of cash inflows and outflows associated with a project. It takes into account the time value of money by incorporating the timing of all the cash flows (1 yr from now, 2 yrs, 3 yrs, etc.) and uses a discount rate to value those future cash flows into today’s dollars. This discount rate can be thought of as the cost of capital or required rate of return and it captures the riskiness of the venture. The more risky the endeavor, the higher the required rate of return will be. After it is all said and done, a positive NPV means that the initial investment has been recovered with the required rate of return and there was still money left over. The best way to perform this calculation is with spreadsheet software like Microsoft Excel.
Performing the calculation on our example would show that the project would have a positive NPV of $30,239 and indicates that it would be a good investment, assuming a required rate of return of 12%. What if her only source of funds was from an investor who expected a 20% return? Under this scenario, the NPV turns negative at -$469 and suggests that the proposal is not profitable and she should consider other alternatives.
Speaking of alternatives, NPV provides a tremendous tool to assess multiple options. Suppose that in addition to the initial example, our business owner had another proposal that would require a $210,000 initial investment but would generate $70,000 net annual cash flow over the same 5-year period (again with no salvage value). Which one, if either, should she implement? The simple payback calculation shows a 3 year payback for both choices. The NPV abalysis (12% required rate of return) shows the NPV of this option to be a positive $42,334. This number is higher than the $30,239 of the other choice and tells her which one is a better use of the firm’s resources because it adds more wealth to the company.
Utilizing quantitative techniques like NPV can help managers and owners make better-informed decisions based on data instead of relying on that “gut feeling.” While there is still some subjectivity involved in projecting future cash flows, it’s better than blindly taking a leap and then trying to figure out after the fact why things didn’t work out.
This discussion provides a brief introduction to the NPV concept. Obviously, the full concept cannot be covered in such a short forum.
By Kerry Woodson
A business owner is in a dilemma. She is trying to decide if a new project for her business is a good idea. The venture will require $150,000 investment up front and will generate $50,000 per year in net cash flow (after expenses and taxes) for the next five years, after which the project ends with no salvage value and no further income. Should she jump on the opportunity or pass? Let’s look at some tools an entrepreneur can use to evaluate potential business projects to determine if they are worthwhile investments or uses of the company’s limited resources.
One calculation many managers have used for years is a simple payback analysis. They would take the initial required investment and divide it by the annual or monthly cash flow and determine how long it takes them to get their money back. In our example, it would take 3 years to recoup the upfront cash outlay (150,000/50,000 = 3). Is this number an acceptable return and does it give a clear indication of the merit of the project? The short answer is that it depends on other factors and is what exposes the shortcoming of the payback calculation – it fails to take into account the time value of money and the cost of obtaining capital.
All money has costs associated with its use. These costs can be in the form of actual interest expense to lenders or dividends to investors. Even if it’s your own money, there is an opportunity cost because of the interest lost or by foregoing other investment options. For this reason, any endeavor should provide enough return to compensate for the use of money and any evaluation tool should include this facet in order to give a true picture of the relative merits of the proposed venture. The concept of net present value provides a great way to accomplish these goals.
Simply stated, net present value (NPV) is the difference between the present value of cash inflows and outflows associated with a project. It takes into account the time value of money by incorporating the timing of all the cash flows (1 yr from now, 2 yrs, 3 yrs, etc.) and uses a discount rate to value those future cash flows into today’s dollars. This discount rate can be thought of as the cost of capital or required rate of return and it captures the riskiness of the venture. The more risky the endeavor, the higher the required rate of return will be. After it is all said and done, a positive NPV means that the initial investment has been recovered with the required rate of return and there was still money left over. The best way to perform this calculation is with spreadsheet software like Microsoft Excel.
Performing the calculation on our example would show that the project would have a positive NPV of $30,239 and indicates that it would be a good investment, assuming a required rate of return of 12%. What if her only source of funds was from an investor who expected a 20% return? Under this scenario, the NPV turns negative at -$469 and suggests that the proposal is not profitable and she should consider other alternatives.
Speaking of alternatives, NPV provides a tremendous tool to assess multiple options. Suppose that in addition to the initial example, our business owner had another proposal that would require a $210,000 initial investment but would generate $70,000 net annual cash flow over the same 5-year period (again with no salvage value). Which one, if either, should she implement? The simple payback calculation shows a 3 year payback for both choices. The NPV abalysis (12% required rate of return) shows the NPV of this option to be a positive $42,334. This number is higher than the $30,239 of the other choice and tells her which one is a better use of the firm’s resources because it adds more wealth to the company.
Utilizing quantitative techniques like NPV can help managers and owners make better-informed decisions based on data instead of relying on that “gut feeling.” While there is still some subjectivity involved in projecting future cash flows, it’s better than blindly taking a leap and then trying to figure out after the fact why things didn’t work out.
This discussion provides a brief introduction to the NPV concept. Obviously, the full concept cannot be covered in such a short forum.
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