If you own a successful business, you know how to create value. You put together the machinery and equipment you need, hire smart people, raise the money to run the operation. Then you build some exciting new products and services and hope they will come. You know, paying customers.
But let’s imagine you have a number of opportunities you could invest in. How do you decide which one is the best?
Financial managers ask this question all the time. So, unsurprisingly, they have developed some powerful tools to help them spot the winner investments and weed out the losers.
Example investment project: flipping a house
For example, let’s say you pick up a fixer upper house for a song. Then spend a bunch on bringing it up to snuff. After that, put it on the market. Let’s say you spent $200,000 to buy the house. Plus another $50,000 to make it look decent. So your total project outlay is $250,000.
Now you put the house up for sale and it fetches $300,000. As a result, you pocket $50,000. That’s your reward for the value created.
Enter the net present value
But what if you decide to invest in a business? In other words, you want to know if the cash flows you expect from the company justify your initial investment to get the business going.
In this situation, you don’t plan to sell the company. Instead, you would need to estimate the cash flows you expect to receive from the business in the future. And then compare the value of this cash flow stream to the investment you need to make. How to do this?
That’s where the net present value or NPV comes in. First, you create a cash flow forecast, say for 5 years into the future. Next, estimate the discount rate, or required rate of return on your investment. After that, you would use the discounted cash flow valuation in order to figure out the present value of these cash flows. Finally, you subtract the investment needed from the present value of the cash flows.
The net present value rule
This difference is called the net present value. Acting as a capital investment manager, you ask this key question:
Is the net present value of this investment positive?
If yes, your company has created or added value. So you are looking at a good investment. Otherwise, move on to bigger and better projects.
In other words, investments with a positive NPV create value and you should consider accepting them. On the other hand, the projects which result in a negative NPV destroy value and you should steer clear of these.
Now let’s say you have a specific required rate of return in mind. And you want to know if an investment you are considering can provide you with a return like this.
Well, the financial managers have worked out an answer to this one too. They call it the internal rate of return, or IRR for short. The reason for the ‘internal’ name is that the IRR depends solely on the cash flows from the investment.
The internal rate of return rule
So the IRR rule is this:
An investment is acceptable if the IRR is greater than your required rate of return. Otherwise, you should reject the project.
But how do you figure out the IRR of a given investment? Remember the net present value calculation: you use a discount rate, calculate the present value of cash flows, and compare the result to the investment needed.
Now ask how high the discount rate should go before the net present value turns negative. In other words, the investment hits the break even point so that no new value is either created or destroyed.
The discount rate that gives you this is the IRR:
The IRR is the discount rate that sets the net present value of an investment equal to zero.
So you can screen investments using the IRR tool as follows:
First, estimate the cash flows from the business proposition. Second, look for the discount rate that makes the present value of your cash flow forecast equal to the investment required. This is your IRR. Finally, compare the IRR to your required rate of return.
Pick the projects that offer you the return you want.