If you use a traditional return on investment to make project decisions, you are missing a critical factor for your decision – the time value of money.
Traditional return on investment models simply average the annual net profit expected on the investment and then compare that average profit to the cost of the project for a percentage return. The flaw in that method is that one dollar profit received five years from now has nowhere near the value of one dollar received today.
The only way to calculate the true value of a project is by using discounted cash flow, also known as net present value — the only project evaluation method to take the time value of money into consideration.
Why is money received in a future period worth less than money received today? There are basically two reasons: inflation and the opportunity cost or what that money could have been earning for you if you received it today.
If someone gave you one dollar today, you know with absolute certainty that you could make at least 5% on that dollar without any risk by putting it in a bank CD. Of course, you would also have other options for that money that might entail some risk, but provide you with a greater return.
A sampling of discount rates is shown in the table. Notice that $1,000 received ten years from today is worth only $247 in today’s dollars if that money could have been put in an investment earning 15% per year.
So now let’s bring this time value of money concept back to project decisions. For each project that requires capital, apply this concept to the annual cash flows to see if your project is a winner.
To analyze the net present value of the cash flows or feasibility of any project, we need the following information:
1) The price of the project.
2) The down payment and any financing terms.
3) The annual net profits for the project before depreciation.
4) Any residual value for the project.
Because projections beyond ten years lose a great deal of validity, we will confine our analysis to a ten-year time frame. For any project that produces cash flow for more than ten years, we will assume we liquidate the project at the end of the tenth year.
For each yearly time period from now (which we call the down payment time) through ten years, we will need the following three pieces of information:
1) Cash Outflow – This is typically the project cost, which may be split into a down payment and loan payments thereafter. If the project extends beyond ten years, any loan balance at the end of year ten is assumed to be paid in full.
2) Cash Inflow – This is your bottom-line before depreciation and any loan expense.
3) Discount Factor – Based on the specific opportunity cost percentage you select, a discount factor will be applied to the net cash (Cash Inflow minus Cash Outflow) for each period. Discount factors may be calculated using a financial calculator, or obtained from any financial textbook.
To determine which discount factor to apply, think about the risk in the project. The greater the risk, the higher return you should expect and therefore the higher the discount factor.
In summary, at Meridian we highly recommend the use of discounted cash flow for analyis of any capital expenditure. Whenever you contemplate spending money for anything (buying a store, etc.), take a minute to run a discounted cash flow analysis to be sure you’re making a wise, economically viable decision with your hard-earned cash.
