Net Present Value & the Go, No-Go Decision

Jul 15

When and how should the decision be made to pursue a new project in your business? I think far too often the “Go”, “No-Go” decision is made without consulting the data. Two discussion points that came up over and over in Corporate Finance include the cost of capital and net present value. The cost of capital is the rate of return you might expect if you invested the same capital in another opportunity with similar risk. This is useful because it puts you in the frame of mind of an external investor that has the option of passing on your company with his investment dollars. Using the cost of capital properly can help you make objective decisions. Present value is a calculation that takes the cost of capital into account when calculating the expected return for an investment when considering all cash flows, and their timing. The net present value (NPV)takes in to account all cash investments as well. If the NPV of a project is positive, then it should be pursued. If two projects have a positive NPV, either both or the project with the higher NPV should be pursued. Go, No-Go The point is that far too many entrepreneurs fail to determine the cost of capital that should drive their decision making or to calculate the NPV for a given project. If an NPV is negative, the project should be dropped. You might ask: Should we just do nothing then? Not at all. If you drop one project because it doesn’t produce a positive NPV, look for other projects, or invest your capital where it is likely to get the same return. My point is this: Don’t be afraid to drop a project because it has a negative NPV. The point of business is to make money, and if you can’t show ahead of time that you’ll make money, there’s little point in investing in the project. In a slightly less sophisticated way, Ed Dale, an Apple loving internet marketer by trade, is saying the same thing this...

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Opportunity Cost of Captial and Present Value

May 23

When it comes time to inform an investment decision, it’s essential to know whether or not a present opportunity represents enough present value to justify the investment. If so, at what level and over what time period. Certainly risk factors in, and with such a broad range of opportunities today, including stock markets, bonds, start ups, etc., there’s a lot to take in to account. The answer to the value and timing of an investment with respect to other available investments is given by the Present Value formula (ref for all equations). where P is the present value C is the anticipated future cash flow r is the interest rate of an alternative investment of similar risk t is the number of investment periods. This may change depending on compounding Another way to look at this is as a cash flow C and a Discount Factor D. where The rate r above is the opportunity cost of captial, or opportunity cost. Note that for multiple cash flows, the equation can be summed  Amount, Time and Risk From an investment perspective, the focus of the above equation is cash flow. More specifically, Amount of cash flow Timing of the cash flow Risk associate with the cash flow All three items factor in to the present value formula, and the present value formula informs many financial decisions, including being the basis for perpetuity and annuity analysis and...

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