Businesses have to make investment decisions all the time. Deciding on whether to proceed with a project can be tricky if you are faced with multiple projects with differing profits and timelines.
The most useful tool to use in such situations is net present values (NPVs).
In an earlier blog, I explained the use of IRR (internal rate of return) to evaluate an investment http://bit.ly/1jLg5p8
Whilst this is a great tool, it can be limiting when a business is faced with multiple projects, with differing cashflows in different time periods, some of which can be negative in the middle of a project.
The NPV method gives a total return for a project by calculating the net present values of each of the projected cashflows for each future period by using a discount rate. This method puts a time value on the funds generated by a project. The NPV of the project is also the value added to the business if the project is undertaken.
Essentially it assumes that the cash generated in a future period is less valuable than cash generated today, for e.g. we would all rather have £1 today than in a year’s time. So the cash generated by a project in year 5 is less valuable than the same cash sum generated in year 1. It is important to make sure you use projected cash flows rather than profit figures when evaluating projects.
If the total NPV for a project is positive, it is viable and if the NPV is negative, the project will lose money and should not be undertaken.
The discount rate used is usually the cost of capital to the business – e.g. if the shareholders require a 20% return and no debt is required, then the rate to use is 20%. However, most businesses would borrow funds to invest into new projects, so the weighted average cost of capital should be used. Say the borrowing costs an interest rate of 10%, in simple terms the weighted average is 15%. However, the calculation of the weighted average capital for a business can be quite complex and I won’t go into it here.
If I take an easy example used before in my blog on IRR, say the capital outlay of a project is £250,000 at the outset and the cash inflows £50,000 in year 1 with £75,000 cash inflows from year 2 to 5 and using a discount rate of 15% (and the excel NPV function), the total NPV for the project is a negative £20,327.
So the project should not be undertaken since it will not return more than the 15% hurdle rate used to discount the cashflows. However, the IRR for the project is a positive 12%.
This is why the NPV method is a powerful tool for evaluating whether to undertake an investment or not.
If we use a discount rate of 10%, then the NPV is a positive £11,581. If the rate required is 10% then the project is viable.
Using different tools such as NPV and IRR should not be mutually exclusive and it is worth using all the tools you can to evaluate the potential returns from investments. Usually financial experts will also use the discounted payback period in addition to the above 2 tools.
This is how many years to takes to recover the initial investment – using our example above, the discounted payback period is in year 5, i.e. when the total discounted cashflows exceed the £250,000.
Using a combination of tools will get you the right answer but in all cases, I would also advise to evaluate the risks associated with each project.