As a small business owner, you’re often faced with decisions about what’s best for you and the financial health of your company. Don’t worry. There are several finance methods and models to help you make sound choices, including net present value, opportunity costs, and the internal rate of return formula.
Net Present Value
Net present value (NPV) is a method used in finance and business to determine if a particular project is worth pursuing for your small business. Learn more about NPV and how to calculate it, and check out an example comparison of various projects using net preset value.
What Is Net Present Value?
NPV is a quantitative measure that takes into account your projects cash inflows, cash outflows, and the time value of money to determine if undertaking a business project is a good idea for you. To put it another way, NPV is a capital budgeting tool that analyzes the profitability of a project or projected investment.
Net Present Value Formula
The formula for NPV takes into account four variables:
- C(t) = Net cash flow during period t
- C(0) = Total initial outlay
- r = The discount rate
- t = Number of time periods
The formula is:
NPV = the sum of: (C(t) / (1 + r) ^ t) – C(0)
Example Net Present Value Calculation
As an example, assume your project expectation is five years. The expected cash inflows from the project for each year are:
- Year 1: $5,000
- Year 2: $7,000
- Year 3: $10,000
- Year 4: $12,000
- Year 5: $15,000
The assumed discount rate is 7%, and the initial cost of the project right now is $25,000. The discounted cash flows for each year are:
- Year 1: $5,000 / (1 + 7%) ^ 1 = $4,672.90
- Year 2: $7,000 / (1 + 7%) ^ 2 = $6,114.07
- Year 3: $10,000 / (1 + 7%) ^ 3 = $8,162.98
- Year 4: $12,000 / (1 + 7%) ^ 4 = $9,154.74
- Year 5: $15,000 / (1 + 7%) ^ 5 = $10,694.79
The sum of these cash flows equals $38,799.48. Thus the NPV for your project is:
NPV = $38,799.48 – $25,000 = $13,799.48
Comparing Business Projects With Net Present Value
The most desirable projects to accept and pursue are those with an NPV greater than $0. A positive NPV means that the earnings from your company’s project exceed the initial costs of the project. In other words, a positive NPV implies profitability. A negative NPV indicates that the project doesn’t produce sufficient cash flow to cover the initial capital outlay. It loses money, and it’s best to avoid the project.
Assume you conduct an NPV analysis on five projects and conclude the following:
- Project 1 NPV = $10,000
- Project 2 NPV = $3,300
- Project 3 NPV = ($2,500)
- Project 4 NPV = $0
- Project 5 NPV = $4,000
In this example, it is clear that projects 1, 2, and 5 are profitable. It’s advisable to pursue the highest NPV project first. If your company has enough capital in its budget to pursue all three profitable projects, even better. Projects 3 and 4 aren’t a good option for your small business.
When conducting NPV analysis, it is always wise to do the analysis using multiple discount rates, as this assumption can easily alter the net present value.
At some point, you may need to decide whether to add new services or try to bring in more clients with existing services. Whichever route you choose, you expect the benefit of increased sales. If you have to choose between those two business plans due to resource constraints, you get the benefit from pursuing one business plan while forgoing the benefit from the other.
Such decision-making between two opposing business opportunities incorporates the evaluation of opportunity cost, which often uses net present value, a proxy of the potential benefits from two opposing choices.
Understanding Opportunity Cost
The opportunity cost is really the benefits that you lose by choosing to do one thing instead of the other. The key point behind opportunity cost is that two mutually exclusive courses of actions may not provide the same level of benefit, leading to the need to make a decision.
To further complicate the matter, you can only estimate the future benefit each option may produce. You choose what you think is the best option at the time and risk not actually getting the best result from that chosen course of action.
In other words, if the option you didn’t choose actually produces more benefit than the option you did choose, you incur the opportunity cost, equal to the benefit differential between the return of the more lucrative non-chosen option and the return of the less beneficial that you chose.
For example, you decide to go with Opportunity A and receive a benefit of $5,000. If Opportunity B offered a benefit of $7,000, then the differential is $2,000.
For a better chance of choosing the option with the higher return, make your decisions by incorporating the opportunity cost and evaluating potential outcomes based on net present value.
Evaluating Opportunity Cost
The decision-making process can cost money in itself. You direct resources at it when investigating two potential courses of actions. You may spend more money evaluating one option and less on the other. Such expenditures are sunk costs, the money that is spent and gone, and you don’t incorporate them into the decision-making.
The option of receiving more investigating dollars may have a lower estimated return. You shouldn’t go with an option just because the resource devoted to it is too much to ignore.
For example, Opportunity A costs $500 to investigate and offers a return of $5,000, while Opportunity B costs $300 to investigate and offers a return of $6,500. You don’t want to choose Opportunity A just because it costs more to investigate.
It’s best to base your decision on the net benefit that a chosen option can provide. The net benefit that a future course of action may produce can be best expressed in net present value. Net present value is the sum of an investment’s expected cash inflows from future years valued in today’s money minus the initial investment outlay.
For example, you could invest a certain amount of money to get new services up and running, or you could market your existing services to more clients. If your analysis indicates that additional marketing of existing services has a higher net present value than plotting out new but untested services, you should choose to market your existing services as a way of expanding your business. If the proposed new services later actually catch on with customers and generate more net sales, you lose the extra benefit and incur an opportunity cost.
Choosing between offering new services and marketing existing services is a matter of evaluating the opportunity cost and using net present value for benefit comparison. Once you make your decision, it should incur as little opportunity cost as possible.
Internal Rate of Return
The internal rate of return (IRR) is used in capital budgeting to measure the profitability of investments or projects. Learn more about IRR, see example calculations, and learn how to use this tool to make decisions about whether your business should pursue a project.
What Is the Internal Rate of Return?
The internal rate of return is the annualized effective compound rate of return for a project or investment that makes the net present value equal to zero. In other words, the IRR is the annualized return that makes the project or investment break even — essential how much you earned and how much you spent are the same amount. The term “internal” refers to the fact that the calculation doesn’t include any external factors, such as inflation or interest rates.
The Internal Rate of Return Formula
The formula for the IRR takes four variables into account:
- P(0) = The initial cash flow of the project or investment
- P(t) = The cash flow at period t,
- t = The time period in question
- IRR = The internal rate of return
Remembering that the IRR is found to equate the project’s cash flows to zero, because zero is the break even spot, the formula is:
0 = P(0) + P(1)/(1 + IRR) + P(2)/(1 + IRR)^2 + P(3)/(1 + IRR)^3 + … + P(t)/(1 + IRR)^t
You can’t really find the IRR numerically. You have to find the solution by using an iteration process to converge on a net present value of $0.
You can do this easily within a spreadsheet by using “what if” and “goal seek” functions. Also, in cases where there are odd patterns of cash flow, such as positive ones followed by negative ones, followed by positive again, multiple IRR solutions can arise. Unsure? Don’t worry, you can check out the example.
Example Internal Rate of Return Calculations
Assume a project has an initial capital outlay of $450,000. It will last for five years, and the cash flows generated from the project are estimated to be:
- Year 1: $125,000
- Year 2: $150,000
- Year 3: $150,000
- Year 4: $100,000
- Year 5: $60,000
The IRR equation is set up as:
$0 = $125,000/(1+IRR)^1 + $150,000/(1+IRR)^2 + $150,000/(1+IRR)^3 + $100,000/(1+IRR)^4 + $60,000/(1+IRR)^5
Through iteration, the solution for IRR in this equation is 10.56%.
Making Business Decisions With the Internal Rate of Return
So what does the IRR tell you about your possible investments? A higher IRR means the project is more attractive. When you have to decide between two projects, it’s advisable to select the one with the higher IRR. However, it’s very important that the IRR exceeds your company’s cost of capital. If not, the project loses money for the company, even if the IRR is positive.
The cost of capital is the cost of funds that the business uses, or in simpler terms, how much you pay for the money you need to invest. Debt and equity tend to have different costs associated with them, such as a bank loan that you pay interest on or cash you already have on hand, so you need to calculate the weighted average cost of capital.
For example, assume a manager runs the numbers on three projects and finds the following IRR values:
- Project 1 IRR = 9%
- Project 2 IRR = 12%
- Project 3 IRR = 5%
The company’s cost of capital is 6.5%.
The company wants to avoid Project 3 and pursue Project 2. If the company has enough capital, it may want to pursue Project 1 also.
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