Ever find yourself in a situation where you have to make an investment decision? Either setting up a new business, investing in a property or pondering a project within your business? The decision can, sometimes, be a tough one if we don’t have the necessary tools in our toolbox to help us make a good decision.
The Net Present Value calculation is a technique that helps us to make better decisions based on more variables that go beyond other investment appraisal techniques. It is probably one of the most widely used techniques in professional investment appraisal. It is used when you are looking to understand if a project is viable or not. It tells us the profit generated by the project and if whether it exceeds the initial investment, taking into consideration the term in which you need your money back by and any discounts you need to apply to that income such as costs, interest or required rates of return etc.
The NPV is the difference between the cash inflows and cash outflows, discounted by a rate that the future inflows will be subject to, therefore bringing all income to today’s terms or “present value”.
The tool includes the following variables, which you need to know in order complete the calculation:
Project Term in Years
Cash Outflow/Investment Required
Forecast Cash Inflows for Project Term
The way you know if whether a project is viable or not is from the output of the calculation. The NPV will calculate your result in monetary terms, that will either be more than £0 or less than £0. If it is less than £0 over the project term, then you should not progress with the project. Where however the result is a positive figure that is above £0, then the project, in theory, is positive and therefore, cashflow positive and able to pay off liabilities such as costs and return you initial investment.
I’ve created a calculator for some projects I am working on and have made it available for you to download here.
The calculator is limited to a project term of five years, as most forecasting is just guess work after that.
If you would like to level up your NPV game, you can read my blog post here about calculating your discount factor or ‘WACC’ – Weighted Average Cost of Capital.
Hope it’s useful. If you would like the calculator tailored, please email me and I’ll be happy to help.
You may be in a situation where you need to make an investment decision. You’ll already know that one of the worst possible ideas you can have is to keep it in a bank; you’ll see from a previous post here, that keeping your money in the bank will probably leave you worse-off.
With this spare money, you, as a savvy money person, in theory should be looking for opportunities to grow your money to make your money grow; this could either be to gather a return 40 years down the line, or to gather a return 2 years down the line. In any event, the ultimate objective is to grow money and make it work for you, resulting in the creation of value. The opposite is worse-off by not using it properly and being subject to forces like inflation and interest rates.
I must start with a disclaimer that most investment opportunities come with risk. The underlying principle of risk is that the more risk you are asked to take, the more you should be rewarded for it; that’s why Government bonds are so low yielding – this is mainly because of their low-risk nature, relative to a business deal or stock opportunity. Risk even comes with keeping money in your bank, but the low return on your money suggests that a bank is also low risk. This is a good article that describes the risk-reward relationship in more detail. It is to be noted that everything comes with risk and in this article, I assume you are assessing risk relative to your risk appetite as required. If you’re not comfortable with an opportunity and it doesn’t “feel right”, then it’s too risky for you – simple!
So the three things to take into consideration when considering an investment opportunity are (in this order):
1. Return on Capital Employed or “Return on Employed Capital”; “Return on Invested Capital”; “Return on Capital Invested” The ROCE measure tells us what the percentage profit return is on the money we invest is i.e. the amount of profit a person makes as a percentage of their total money invested.
This is probably the most widely used measure used to determine an opportunity’s profitability. It takes in to consideration the income generated by the opportunity relative to the amount of money that is to be invested and presents this as a number in percentage terms.
What’s also important is that it is a percentage based measure; this allows us to compare the ROCE with other opportunities to see which is more profitable, irrespective of opportunity figures or size of investment. This is useful in the event you have two opportunities and don’t know which to invest in.
Ensure this figure beats your bank interest rate and inflation where possible. The higher this figure is, the better.
2. Time Value of Money or “TVOM” Okay, so with your ROCE measures in your hand from two opportunities (#1 & #2) for example, it’s now important to know how long it will take for your return from each opportunity to materialise. This is important because although ‘opportunity #1’ may offer an ROCE of 45% and ‘opportunity #2’, 30%, the time difference between these two opportunities may influence the investment decision.
Fathom this: ‘Opportunity #1’ will give you your initial investment + 45% return in 30 years and ‘opportunity #2’ a 30% ROCE in 10 years. Naturally, based on a quick back of envelope calculation, most people would go for ‘opportunity #2’ otherwise the investor may be waiting an extra 20 years for a further 15% return! Furthermore, if you break it down to a yearly basis, it would suggest ‘opportunity #2’ is more profitable across the project term, despite the lower ROCE! – this is why time period is important.
Anyway the real reason the measure of how long the opportunities will take to materialise a return is important is because (a) the longer it’s taking to get your money back, the more opportunities you may be missing to generate either an equal or higher return. Secondly, (b) as time progresses, the value of each pound tied up in both your initial investment and anticipated return is uncertain. The value of the pound may fluctuate and worst case, be worth less in the future than today – think of quantitative easing or inflation and these diminishing the value of the currency, therefore rendering that same pound less valuable in the future, not being able to buy the same amount of things as it can today. So the quicker the return, the better, because you can use money in your hands today, based on todays value to invest to either generate more money or buy more things instead of tomorrow’s uncertain value.
3. Opportunity Costs And lastly, the opportunity cost. When investing in something, you’re tying money up in to something that you won’t have access to for a certain period of time, therefore where opportunities arise in that period and where the money is tied up, you won’t be able to capitalise on them because you don’t have the funds available, because they’re tied up! Or invested. So on this basis, it is always good practice to understand that, by investing in one of the two opportunities presented, what other opportunities you may be missing out on as a result. For example another opportunity, ‘opportunity #3’ for instance could be a lower returning opportunity that comes with less risk that might work in line with your investment objectives or risk appetite. It could even be similar return, but in a different project that you may know more about. In simple terms, it’s the consideration of any other opportunities that you will miss out on because the money is tied up elsewhere.
There are other things that could be taken in to consideration e.g. if the return is fixed or compound based or ensuring the level of reward is proportionate to the level of risk, but I think the above three measures enable any lay person to make a good, considered financial decision, enabling your money to make you richer.
The Weighted Average Cost of Capital! Also known as, WACC.
A discussion I had with a friend inspired me to write this post; we spoke about calculating the absolute minimum return a project would need to generate, in order for the project to be deemed feasible.
What is WACC?
WACC is a figure that a company would have to pay to providers of capital in exchange for borrowed capital; sources could be banks, investors, businesses etc. You would typically use WACC when there is more than one source of capital; where there is only one source, you would not necessarily need to calculate an average, weighted, rate of return, as there would only be one figure/interest rate and that would serve as your WACC. This WACC is a the return that you must generate as a bare minimum, to at least keep creditors happy and break even. The assumption however is to generate a return that exceeds the WACC to create a profit for yourself too of course.
Why Would You Use WACC?
You would use WACC to calculate the absolute minimum return you must generate from your project; anything above this base figure is potential profit in your pocket. The Weighted Average Cost of Capital calculation is also used to decide if whether it is feasible to progress with a project based on the cost of the project against the return on the project. If for example, the profit, in percentage terms, does not exceed your cost of capital, then the project should be rejected – you wouldn’t be able to even generate an amount that will pay off the creditors! Therefore, do not progress with the project!
You want to borrow money from a number of sources to buy a building and convert them in to single-let flats.
You’re a business that wants to purchase another two retail units and in order to do so, will have to borrow money from the bank and two other investors
You want to stock your furniture shop up and have borrowed capital from one bank and a family member.
Right, here’s how you calculate WACC. Let’s say for example you need £200,000 for a building that you want to buy to convert in to single-let flats. The £200,000 includes the purchase price and cost of works. You know four people that will fund your project, either through a joint venture, simple interest based borrowing, bridging loan etc. Let’s say you have four sources for capital and they are as follows:
Source 1: Source: Bank Capital secured: £70,000 Interest rate/required rate of return: 8% per year
Source 2: Source: Bridging Company Capital secured: £75,000 Interest rate/required rate of return: 14% per year
Source 3: Source: Hands-off Investor #1 Capital secured: £25,000 Interest rate/required rate of return: 7.5% per year
Source 4: Source: Hands-off Investor #2 Capital secured: £30,000 Interest rate/required rate of return: 8.5% per year
Note: It is worth noting at this point that all sources have different required rates of returns/interest rates in exchange for the money they’re giving you for your project. The next question is, how do you calculate, in percentage terms, how much you need to generate from your project to pay them all back. I talk in percentage terms because often profits and rates (interest, WACC, tax etc) are presented in percentages (yield, return on investment, return on capital employed etc); this makes them directly comparable. Now the calculation you do is as follows:
The above calculation is based on the following:
WACC = Weighted Average Cost of Capital Source Amount = The amount that has come from one particular source Total Amount = The total figure gathered from all sources; £200,000 for this example RoR = Interest OR Required Rate of Return
For the above project, 10.26% is the Weighted Average Cost of Capital and the minimum return you would need to generate from your project. Anything above this figure is money in your pocket. In the event, you know, based off other due diligence you have done, that you will get for example, a 23% return on investment for this project, you would deduct 10.26% from this 23%, leaving a tidy 12.74% potential profit for you.
You could incorporate tax in to this calculation by simply adding the tax rate that you expect to pay at the end, but I have intentionally left this out, as I know at this point, creative tax strategies are typically employed to offset or deal with tax more efficiently.
Last note; you may see people differentiate between the cost of equity (your money) and debt (somebody elses money). I haven’t got too complex with this calculation, however you would superficially be able to treat equity (your own money) as a form of debt. This is due to the fact that when you invest your own money, there is what’s called an opportunity cost by investing equity in the project because you could invest that money elsewhere to generate a return and as a result, a rate of return would be required – you could go a step further if a company is using it’s own money and calculate the value of shares + any loans taken by the company and use that as a cost of capital – talk to me for more detail. And lastly, as there is more risk with debt; often this is factored in to the rates of returns.
Last, last note; calculating the WACC can prove to be very useful and is the early stage of an investment/project appraisal, because all this calculation tells you is how much would be required to pay your creditors. The next step would be to calculate if whether the project would be cash-flow positive and this is where discounted cash-flow calculations come in, but we’ll talk about these later though.
Falling asleep now. Hope I haven’t made any spelling mistakes. Good nigt.