It's amazing how large capex plans for investment in plant or machinery can be authorised at even large multinational firms without a view of what kind of return on capital may be achieved or even a quantitative assessment of which option may provide the greatest cashflow. In this article we'll cover the basic concept of Net Present Value, also referred to as NPV for determining the value of an investment.
It's all about cash(flow)
In the hustle & bustle of daily work, it's easy to get swept up in project fever to lose sight of why businesses operate: to make money, or more specifically generate profits for return to shareholders. That's it. That's the modus operandi, the raison d'être so to speak. However, in life, individuals are usually faced with the choice of many options when it comes to deploying capital. "Should we buy building X or purchase machinery Y?." The thought process in finally deciding which option to go for requires both a quantitative and qualitative lens but should always centre around the idea of choosing the option that will maximise net positive cashflow in the long run. Cash flow is essentially the money coming in and the money going out of a company. If you spend £10,000 on machinery that allows you to sell £3,000 worth of products each year and will last for 5 years before needing to be replaced then the net cash flow from purchasing the machine is £5,000 ((5 years * £3,000 = £15,000)-£10,000 cost of machine). Wow. That seems like an attractive investment, right? Hold on,... let's first tackle subjectivity before digging a bit deeper.
The subjective aspect of capital allocation comes when an investment decision is being made for strategic reasons with a view that it will generate cashflow in the future, for example a farmer buying undervalued farmland which currently has low cashflow but realising that the land will compliment his existing farm allowing him to create economies of scale that drive down costs, thereby increasing profits in the future. Another example could be that by selecting 'location A' versus 'location B' for investment, a company may be able to attract a higher quality workforce which wouldn't necessarily be reflected purely by cashflow but would nonetheless have an impact (a more productive workforce can produce more / higher quality goods, thereby driving output). You'll notice with the examples, there are a lot of "if's" and "but's" but that's why they are important to consider together with quantitative facts as it allows for a more informed debate when making large investments based on a clear set of facts and assumptions that can be tracked.
Cash today is worth more than cash tomorrow
Going back to our example of the machinery costing £10,000 but bringing in £15,000 in cash flow, while the net cashflow is £5,000 this isn't necessarily what the Net Present Value or NPV is because of two reasons.
1) We need to consider how much the machinery might be worth after 5 years, is it really worth zero or could it be sold for £1,000 for example.
2) The £15,000 in cashflows assumes zero opportunity cost, but in reality, £15,000 in your hands today would generate interest each year so is worth more than £15,000 in the future.
On point (1), for our example, let's assume the machinery will have a re-sale value of £1,000 at the end of its economic life after 5 years. On point (2), we need to realise that if you have to wait 5 years to get cash back from an investment then there's an opportunity cost associated with that be it in the form of perhaps being able to buy a second piece of machinery that would have generated even more cashflow, or quite simply interest from a savings account that would accrue if you had the £15,000 in a bank account. Economists call this the "discount rate" applied to capital.
At KStar Associates, we typically hold an aggressive view on capital and seek a discount rate of 12%. At a time when interest rates are at record lows, this may seem high but it forces capital discipline. Most companies will simply look at the safest interest rate (or return on capital) they can achieve as alternative options and apply that as a discount rate. With the example of the machinery, year 1's cash flow of £3,000 in 12 month's time would be calculated as:
- £3,000 cash flow
- 12% discount rate
- 1 year time period
- NPV = (£3,000 / (1+0.12)) = (£3,000 / 1.12) = £2,679
As you can see, with a 12% discount rate, £3,000 in a year's time, most definitely is not worth £3,000 today! From our experience, people tend to 'fudge' the discount rate being used to try and justify investments that would otherwise not be attractive from a capital allocation perspective. It's important to ensure strict change control on the discount rate used by teams seeking investment to ensure a consistent yard stick is applied for all projects.
NPV for our machinery example
Applying the net present value approach beyond just year 1's cashflow will provide a full picture in terms of what the Present Value is for the machinery that costs £10,000:
+ £4,000 (£3,000 + £1,000 re-sale value)
Total PV £10,814
Taking into consideration all of the cashflow, the present value of these would be worth £10,814 today, i.e. in present terms. To obtain the NPV, we have to deduct the original purchase cost of the machinery.
NPV = (£10,814 - £10,000) = £814
When thinking about investment decisions in this way using NPV, it forces capital allocators to consider what the equipment will be used for, how much value it will generate versus the expense, and also how long it will last for. With this example we see that the significant outlay would only result in £814 of value in terms of today's money. While that is good, the question is worth asking whether the reward of £814 is worth the risk of £10,000 especially against other strategic options for cash investment. This takes us to risk/reward ratios which we will cover in a future topic.
If you have questions on this piece or wish to discuss how it could work within your organisation, please do not hesitate to reach out and contact us for a free no-obligation consultation. Similarly, feel free to share this article & link back to our site using the buttons below. We’re always happy to help.
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