Last week’s blog post talked about how to calculate an internal rate of return for your small business investment returns. But you probably also want to know how to do small business net present value calculations.
No, no, I admit it.
This is sort of boring stuff. But it’s pretty important because it can add massively to your long-run profitability and wealth building.
Accordingly, I want to talk here in gritty details about the problems with the internal rate of return measure and then about how you workaround those problems using the net present value measure.
Tip: You might want to refer back to last week’s blog post about small business investment returns if you’re not at least passingly familiar with how an internal rate of return calculation works.
The Problems with Internal Rate of Return Measure
The internal rate of return measure provides a useful way to size up investment returns, including returns on investments in your small business.
But the measure also suffers from three weaknesses.
A first weakness—and one I’ll mention only in passing—is that you can’t always do the calculation and get a unique result. Sometimes the formula isn’t solvable. And sometimes the formula returns multiple correct solutions. You can get a more detailed discussion here if you’re interested. (You’ll need to scroll down to the discussion of the =IRR() and =NPV() functions.)
A second weakness of the internal rate of return measure is that you don’t necessarily maximize your profits when you use it—only your rate of return. This sounds weird, but a quick example shows you what this means. Suppose you have two investment options: A $1,000,000 opportunity that generates a 15% IRR over the next ten years or a $500,000 opportunity that generates a 25% IRR over the next ten years.
On the face of it, the 25% return seems pretty good. But you’re (initially at least) earning that return on a lower investment amount. You see the problem. What you want is a clean way to identify the investment opportunity that clearly and plainly delivers the best absolute dollar return. (It turns out that the smaller investment in this case makes you more money. Just so you know.)
A third weakness is that an internal rate of return doesn’t let you incorporate the rate you’ll earn on the profits you reinvest. Again, a quick example shows you what this means. If you can invest $1,000,000 and earn 50% for one year or invest $1,000,000 and earn 20% for five years, you don’t know which option is best unless you make an assumption about what happens in years two through five for that first option.
Maybe you’ll earn 50% for a year and nothing for the next four years. In that case, you’ll clearly come out ahead with the option where you tie up your money for five years and earn 20%. But what if you can invest the proceeds from the “50% in a year” investment and earn 10%? What produces the best result in that case? Tricky, right?
Fortunately, you and I have an easy tool that fixes all three weaknesses: the net present value measure.
Small Business Net Present Value Calculations
What the net present value formula does is calculate whether a particular small business investment achieves, exceeds, or falls short of a specified rate of return. The calculation result the formula returns is the current day, or present value, amount that an investment generates in excess of the specified rate.
To use the formula, you need to specify the rate of return you insist your small business investments produce. In a small business setting, you would probably set this hurdle—people sometimes call it a hurdle rate of return—to something like 15% or 20% or even 25% annually.
But the math works pretty straightforward. Let me show you.
The table below shows the example cash flows discussed in last week’s blog post about small business investment returns:
| Cash flow | |
|---|---|
| Year 0 | -$40,000 |
| Year 1 | $6,000 |
| Year 2 | $8,000 |
| Year 3 | $10,000 |
| Year 4 | $12,000 |
| Year 5 | $64,000 |
If you wanted to measure the internal rate of return and these cash flows are stored in the Excel workbook range A1:A6, as noted in the post last week, you would use the formula
=IRR(A1:A6)
which returns the value .2576, which means a 25.76% internal rate of return.
If you wanted instead to measure the net present value, and if these cash flows are stored in the workbook range A1:A6 and the hurdle rate of return equals .2, or 20%, you would use the formula:
=NPV(0.2,A1:A6)
which returns the value $6541.50.
Here’s the critical point. That $6541.50 value means the investment beats a 20% annual rate of return by $6541.50 in current day dollars. And so you’ll know whether the investment result good by comparing this dollar result to dollar results of your other investment options.
If you have two investment options, you pick the one with the higher net present value. That’ll be the investment option that generates the most profit.
If you have several investment options, you want to collect the set of investment options that as a group give you the highest total net present value.
And two other minor points: First, if some investment produces zero net present value, that means the investment delivers a return (actually an internal rate of return) exactly equal to the hurdle rate of return. Second, if some investment produces a negative net present value, that means the investment falls short of your hurdle rate.
Summarizing the Appeal of a Net Present Value Approach
Can I also just elaborate a little bit on the beauty of the net present value formula?
Think back to those internal rate of return weaknesses I highlighted a few paragraphs ago.
With an NPV calculation, you’ll always be able to calculate a solution and there’s actually only going to be a single solution.
With an NPV calculation and a situation where you’re comparing a big investment to a little investment, you’ll know the profitability in dollars and so be able to identify the highest profit choice.
Finally, with an NPV calculation and situation where you’re looking a short-term higher return option and a long-term, lower return option, you’ll implicitly deal with your reinvestment risk. (The NPV calculation assumes the hurdle date—20% in our example here—is the reinvestment rate.)