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Dont miss Part 1 of the Measuring ROI series: Using the Payback Approach, by Jon Allen
The goal of financial management in a company is to maximize the value of the company’s stock. Managers need ways to determine whether a project being considered will add value to their companies. This is the second in a series of three articles that discuss methods for evaluating the financial benefits of projects. The first article discussed the payback approach and noted several serious shortcomings of that method, although for quick analysis of small-dollar projects it still makes sense to use. A far-better method for larger projects is the net-present-value approach.
Net present value (“NPV”) is the present value of the cash inflows of a project less (net of) the required cash outlay. An important concept in finance is that the value of money is affected by when it is received. The opportunity to do something productive with a dollar today that cannot be done without it today has value. All other things being equal, projects that generate cash earlier have more value than projects that generate the same amount of cash but later.
The process of adjusting future cash flows to a value that is relevant in the present is called “discounting” and requires the use of an interest rate. In determining the appropriate rate, companies should consider the risks of the project, the degree of confidence they have in its cash-flow projections, and what could be earned in alternative projects. Greater risk and uncertainty in financial projections warrant higher discount rates. Lower risk and more-reliable projections warrant lower discount rates. The higher the discount rate, the more cash flow a project has to generate in order for it to be accepted. In normal economic times discount rates are typically between 8% and 14%. However, in times of ultra-low interest rates, a range of 5% to 10% might be more appropriate.
Because NPV adjusts for the time value of future cash flows, it overcomes the major drawback of the payback approach and gives the appropriate weight, assuming a given discount rate, for all of a project’s cash flows regardless of when they are expected to occur, and compares them to the initial cash outlay. If the discounted cash inflows exceed the initial cash outlay, then the project will have a positive NPV and should be accepted. If they are less than the initial cash outlay, then the project will have a negative NPV and should be rejected because it is not expected to earn enough, after adjusting for the time value of money, to justify the initial cost.
Consider the same example we used in the previous article: Acme, Inc. is considering buying a new machine. The initial cost of that machine is $1 million. The machine has an expected life of five years and is expected to generate cash flows, net of all expenses, of $250,000 per year for each of those years. This time assume that Acme uses the NPV approach rather than the payback approach to analyze new projects and has determined that it will only accept projects that have positive NPVs.
In Table 1, let’s assume that because Acme has a high degree of confidence in the projections and believes this project has little risk, it uses a discount rate of 5%. The NPV turns out to be $82,369, meaning that the expected future cash inflows of the project, discounted to the present by a rate of 5% and added together, exceed the initial investment of $1 million by $82,369, and therefore the project should be accepted.
Now let’s assume that Acme is not so confident in its projections and believes that because of risk, the appropriate discount rate for the project should be 10%. Table 2 uses the same expected cash flows as in Table 1 but changes the discount rate to 10%. In this case the expected cash flows are discounted to a greater degree and are not enough to make up for the initial project cost. Therefore the NPV is negative and the project should be rejected.
Obviously the selection of a discount rate can make a big difference in the NPV of a project. If you recall from the first article, this same project reached “positive payback” at 4 years and Acme chose to accept it based on the payback approach. Table 2 shows that for a discount rate of 10%, that was the wrong decision.
The NPV approach has no significant flaws and is the preferred method for evaluating projects because it considers risk and the time value of money, and has no arbitrary cutoff.
In our next issue we will discuss internal rate of return as a way to determine whether a project adds value to a company, and if so, how much.
Jon Allen is the Chief Compliance Officer for Bank of American Fork. Allen (B.S. Brigham Young University, J.D. University of Idaho) teaches Introduction to Corporate Finance as an adjunct at Utah Valley University’s Woodbury School of Business. Before becoming Bank of American Fork’s Chief Compliance Officer, he was a commercial loan officer at Capital Community Bank. He has taught at the American Bankers Association’s National Compliance School and serves on ABA’s Compliance Administrative Committee. Learn more about Bank of American Fork at www.bankaf.com, Facebook or Twitter.
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