Wednesday, April 16, 2014

Net Present Value - Understanding return on investment in consideration of the time value of money.

Key Terms: Net Present Value, Net Present Value Discount Rate, weighted average cost of capital, time value of money, inflation.

In 1950, the median value of a home in the United Sates was $44,600. By 2000, this value rose to $119,600. During that time, population increased, but so did inventory, to the point that today there are more houses than people who can afford to buy them. What can explain this - inflation, rising wages, a housing bubble? In reality, the historical increase in prices over time is due to a combination of complex economic factors. However, this bit of history does illustrate an important fact: the value of a dollar changes over time and in general, the value of a dollar today is greater than it will be in the future. This phenomenon is sometimes referred to as the time value of money.

When businesses evaluate the economic benefit of an investment that provides returns over time, it is important to understand the value of those returns in terms of the value of a dollar today. If I implement a solution that saves me $200,000 a year in operating expenses, but costs $1,000,000 to deploy, it will take me five years to save $1,000,000. Five years from now, however, that $1,000,000 won’t have the purchasing power that it does today and meanwhile, I might have invested $1,000,000 in the stock market and made a greater return over the same five years. Which brings us to the second important point: it costs money to spend money, because money has an opportunity cost and a cost of risk. This is often referred to as the cost of capital.

A related concept in investing is the uncertainty principle. No, this has nothing to do with Heisenburg or electrons. What we mean by uncertainty (or certainty) is simply, “What is the risk that I will see the projected return on investment?” In making investment decisions, commonly the investment is made in the near-term and benefits come later.  If I spend a dollar today in exchange for the promise of a dollar next year, I am trading certainty (my dollar is absolutely gone) for uncertainty (maybe I will see a return on that dollar next year, or maybe not).  So I need compensation for the uncertainty I am accepting.  The greater my perception of future risk, the more compensation I will want. The uncertainty factor drives me to discount the value of these future returns, because I want to see that I still generate positive returns after factoring the cost of risk that I will realize these returns into the cost of my investment.

When I make an investment, I want to know that (a) my return over time will be a profit in terms of the value of a dollar today (the time that I make the investment, not the time that I realize the return),(b) that I have a reasonable chance of meeting or beating the return I would make on another investment of the same amount.  

The calculated value of the future returns of an investment that takes into consideration the time value of money is called the net present value (NPV) of the investment. Essentially, the net present value calculation applies a compounding discount to the returns you receive on an investment by an average rate to demonstrate the effect market pressures, like inflation and missed opportunity cost, have on the value of your investment. This discount rate is sometimes called the weighted average cost of capital. A higher net present value discount rate results in a lower return, representing a higher average cost of capital over the time frame under consideration. Many organizations have a specific NPV discount rate they use to evaluate certain kinds of investments. It is a good idea to ask your customer if their organization uses a standard rate and to use that rate in your calculations. 

In general, a net present value that is greater than zero represents a positive return on investment, an NPV less than zero means the returns gained did not cover the original investment and an NPV of exactly zero represents a break even scenario. 

NPV is used to inform a lot of other commonly used financial metrics. ROI is based on the net present value of the returns of an investment divided by the original investment. Payback period is the amount of time that will elapse between a capital outlay and the point at which the NPV of the return of that investment equals zero. Internal rate of return actually projects the NPV discount rate that would be required to make a proposed investment break even over the timeframe under consideration, all other variables being equal. Because NPV is so intertwined with these metrics, it is important to understand and be able to deliver the NPV of any proposed investment if you want to gain the mindshare of a financial decision maker. 


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