Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.
The key objective of a corporate finance team is to find ways to optimize the company's resources, including how to invest cash. In this lesson, we'll discuss three important tools that can be used to analyze the potential of any given investment.
Investment Analysis Tools
Companies generate cash and profits through operations and investments. Operations just consist of making and selling goods and services. From the corporate perspective, an investment is any expenditure purchased with the intent that it will generate more income than it cost during its useful life.
For example, purchasing stock is an investment because the intention is that the stock will increase in value and can be sold at a higher price at some future date. A new piece of equipment might be an investment as well - the intention is that it will produce something worth more than the cost of the machine.
Of course, the challenge with investments is that we can't see the future and, truthfully, neither can finance professionals that are expert analysts and employed by top companies. But we can use financial analysis to calculate our anticipated return on an investment, and then decide if the assumptions of that model are reasonable enough to convince others that the reward is worth the risk.
In this lesson, we'll talk about three analyses we can do: the net present value (NPV), internal rate of return (IRR), and the payback period.
Net Present Value
Net present value, or NPV, is the total value in today's dollars, of all future income from an investment. The important part of that definition is 'in today's dollars.' Remember, money loses its value over time because of inflation, which means the $1,000 an investment may return five years from now isn't worth as much as $1,000 today. NPV accounts for this by discounting all the future income from an investment based on a given rate and time period. When you have that sum, you simply compare it to how much the investment will cost and if the gain is sufficient, you make the investment.
Let's look at an example. Your company can buy a new t-shirt making machine today for $5,000. You've run the numbers and believe that this machine will produce enough shirts that you will make $2,000 a year for the next seven years. Analyzing this investment is not as easy as just saying 'I can spend $5,000 and make $14,000' (seven years at $2,000 per year). You need to be able to compare the value of that $14,000 in today's dollars.
Mathematically, we do that by using the NPV formula for each year of income, then adding the years together. Here's the NPV formula, in which t is the number of years away the return is realized, i is the assumed inflation rate, and P is the amount of money we'll receive.
Let's look at that same equation, applied to the numbers we have in our example for years 1, 2, and 7. To calculate the NPV, we would use that formula for each year and add the answers together. That would be about $12,460. So, is it worth $5,000 today to make $12,460? If that return is acceptable to you, then you would deem this a worthwhile investment and buy the machine.
Internal Rate of Return
Oftentimes you'll hear people talk about their 'rate of return.' The rate of return is the percentage per year an investment returns, calculated by dividing the principal amount by the return. So, if someone says 'my retirement portfolio had a 10% rate of return last year,' they are saying the value of their retirement increased by 10% - perhaps from $100,000 to $110,000. When discussing and comparing investments, sometimes it's easiest to figure out their rate of return and compare those.
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The internal rate of return (IRR) is the discount rate of an income stream that results in a net present value of zero. The IRR is difficult to calculate by hand or using a formula, but there are a number of online calculators that can be used, or you can even just use Excel. Let's look at how you would use Excel to calculate the IRR of the t-shirt machine investment presented earlier.
The cell with the answer, B2, uses the formula '=IRR(B4:B11).' When using Excel, it's important to not forget that you need to include the cost of the project in year zero (which is now). The negative $5,000 is the cost of our machine, followed by the return we get each year.
Since we can estimate that our rate of return is 35.1%, we can now compare this investment to other opportunities. The average rate of return in the stock market is around 8% per year, so 35.1% certainly seems like a good annual rate of return!
The last analysis we'll discuss in this lesson is the payback period. The payback period is pretty simple; it's just how long it will take to payback the cost of the investment.
Going back to our NPV analysis, the NPV of the first three years are $1,942, $1,884, and $1,834, respectively. If we add those up we get $5,660. That means that sometime during the third year, we would hit the $5,000 mark, in today's dollars, of total income. The time between the date of purchase and that date - about 2 years and 4 months - would be our payback period.
The difficulty in using payback period is that it is hard to compare to other projects. Is 2 years and 4 months a good payback period? We don't know. For this reason, it's important to use investment analysis tools like this to compare projects and just as one part of a big decision, not as the single factor in deciding how to invest our money.
Companies, like individuals, need to have a carefully constructed and researched investment plan. For companies, these plans are even more complex because they often involve deciding how to spend millions of dollars in equipment and infrastructure that will be around for 30 or more years.
To do this well, a team of financial analysts and mangers need to understand the tools at their disposal that can help them assess the quality of an investment. Net present value, internal rate of return, and payback period are some of the most common, and useful, investment analysis tools. Net present value, or NPV, is the total value, in today's dollars, of all future income from an investment. Internal rate of return (IRR) is the discount rate of an income stream that results in a net present value of zero. The payback period is simply how long it will take to payback the cost of the investment.
If these tools are used wisely, and together, as part of the decision making process, they can help companies make good decisions and hopefully the best decision.
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