Have you ever wondered how to evaluate if new projects or opportunities should be taken on for your business ? Will they be worthwhile and give your business the big boost that it needs ? Or will the project cause your business to come crashing and tumbling down ?
When it comes to such complex business decisions, the best method to use is the Net Present Value [NPV]. The NPV is the sum of the present value of future cash inflows from a project, minus the present value of the initial costs of the project investment. Mathematically, it is expressed as :
NPV = Cash Flow / (1 + i) ^ t - Initial Investment
The Cash Flow component represents money that is earned and spent in each year after a project has begun. Cash flows include sales revenue, operating expenses, capital expenditures and loan interest. Non-cash items such as depreciation is excluded from the calculation.
The i component represents the interest rate or the discount rate. It is the rate of return that a business entity can earn on a similar investment with same level of risk. Cash flows are discounted in order to take into consideration the concept of inflation or the ‘time value of money’. This concept means that money received today is worth more than money received in the future. Discounting future cash flows to the present value allows us to analyze and compare investment options in a more accurate manner.
The t component represents the number of periods or the duration of the project or investment. It can be x number of years or x number of months. For example, t can equal to 20 years, 60 months or however long the project is supposed to run for.
The Initial Investment represents the initial cost of getting the project started. It is the amount of money that has to be spent perhaps on equipment, property or other relevant items just to kickstart the project.
How to Use the NPV ?
The NPV is an indicator of how much value a project or investment will add to your business entity. After you have crunched the numbers, there are only three likely outcomes :
A] The NPV is positive [NPV > 0] – This means that based on the mathematical NPV calculation, the discounted cash flows will exceed the value of the initial investment. The project or investment is forecast to add positive value to our business. Accepting the project or investment will likely be good for your business.
B] The NPV is positive [NPV < 0] – This means that based on the mathematical NPV calculation, the discounted cash flows will be lower than the value of the initial investment. The project or investment is forecast to deduct value or cause your business to lose money. Accepting the project or investment will likely not be a good decision for your business.
C] The NPV is zero [NPV = 0] – This means that based on the mathematical NPV calculation, the discounted cash flows will be equal to the value of the initial investment. The project or investment is forecast to neither add nor deduct value to your business. You may still choose to accept or reject the project. In these cases, you would also consider qualitative factors promised by the project or investment such as marketing strategy, end goals, market positioning with your customer base, community or social upliftment contributions, environment impact etc. as factors to help you in your decision.
Whatever you choose for your business, always give it the deepest thought from both a quantitative and qualitative perspective.
