Before you begin to think about where the financing will come from, you will have to work out what you are going to do and how much it will be worth to your business. It could be that you have more than one investment project in mind. Whatever your situation, you will find this article helpful. It will take you through some of the common methods of arriving at the value of any investment that can also be used to compare different projects in case you can only afford to do one.
If you are considering buying expensive new equipment or refurbishing existing ones, opening a new factory, or buying a competitor, or developing a new product or expanding into a new market, it is important that you have a reliable means to evaluate each project. Otherwise, you might find out that you have wasted funds on a project that did not deliver the benefits you thought it would.
There are three methods commonly used to compare the benefits of investment decisions
- Payback period – this tells you how long it will be before the initial investment is fully recovered by increased profits or reduced costs and is usually measured in months or years.
- Net Present Value (NPV) – this tells you the value today of all the increased profits and cost savings likely to be generated in the future by the investment you make. It is usually presented as a monetary value.
- Internal Rate of Return (IRR) – this tells you what return you will receive on your initial investment assuming the net present value is zero (which will be the minimum acceptable return, unless you want to throw money away).
If the investment projects you are considering are relatively simple, then you can use the attached tool which will supply the Payback Period, Net Present Value and the Internal rate of Return based on the details you enter. If the cash flow on your projects is very complicated or you don’t know which interest rate to use, you should get professional advice. Your bank will probably be delighted to help.
The further you look ahead, the less certain we can be about outcomes and the less reliable projections become. Each of these evaluation methods require accordingly that all costs, incomes and savings be identified for either the useful life of the investment, or between 5 and 10 years if it is a permanent addition.
Obviously, realistic figures help in the analysis. Using overly optimistic figures could result in making a bad investment decision that costs money rather than makes it, and overly pessimistic figures could mean you miss out on an important opportunity. Seek financial advice if you don’t feel able to work out on your own.
The payback period is easiest to calculate. It is calculated by working out how many months or years it will take for the actual increases in profit or cost savings to pay for the initial investment. If a machine is bought today for $7,500 and is expected to cut costs by $4,000 in year one then half as much in each successive year, the payback period will be 4 years
Savings Year 1 $4,000
Savings Year 2 $2,000
Savings Year 3 $1,000
Savings Year 4 $500
Total Savings $7,500
This figure could be used to provide an estimate of the minimum period you would need to borrow money for.
Net Present Value (NPV) calculations involve making an allowance for the time value of money, which is often simplified to just the current interest rate offered by banks for business loans. In most cases, this will provide an acceptable approximation. In the example above you would start off by working out what the current value of each cost saving would be for instance, a saving of $4,000 in a year from now (using a time value of money of 10%) would give $3,636.36 ($4,000/1.1) as the present value of that saving. From this point, the calculations become more complicated. You can use the NPV calculator here. to work out the NPV for a 10-year period. It comes out to be -835.84 indicating that this might not be a good use of funds.
The Internal Rate of Return (IRR) calculation is calculated by working out what the rate of return percentage would be if the NPV were zero. Or, to put it another way, what would the time value of money have to be for me to at least break even with this project. The calculation is a little complex. If you are that way inclined and fancy a bit of maths, you will find a full explanation here. If you are like most of us and happy to accept the result without needing to understand the mathematics behind it, in the example we are using, the answer is around 3%, again suggesting that this might not be a viable project in a country with interest rates higher than 3%.