There are many different ways you can expand and scale your business. Each requires a certain amount of time, effort, and money. Before committing to any major investment, it’s crucial to assess if it makes sense from an economic point of view.
At the simplest level of analysis, you’ll want to make sure that the return is higher than the cost. So how do you evaluate the investment in a project? Let’s look at the three methods that are most commonly used.
1. Payback period
Payback period is the amount of time it will take to recover the initial cost of investment. The shorter the payback period, the better the investment. It is calculated by dividing the cost of investment over the projected annual cash flow.
Due to its simplicity, the main drawback with this method is that it does not take into account of time value of money. As we all know, a dollar today is worth more than a dollar in the future. Also, it does not take into account of what happens after payback, and thus ignores the overall profitability of the investment. Nevertheless, payback period analysis is a quick way to make a preliminary judgement about whether the project is worth pursuing.
2. Accounting rate of return
Accounting rate of return (ARR) is a powerful tool to quickly assess the return on a given project. It is calculated by taking the average annual profit and dividing it by the initial investment.
Let’s say you want to buy a piece of equipment for $300,000. If the projected average annual profit generated by the equipment is $30,000, then the project has an ARR of 10%. You can use this metric to assess if it exceeds the minimum return you are willing to accept for a given level of risk.
Although the simplicity of ARR makes it a commonly used metric for assessment, this simplicity also leaves out a number of important aspects. ARR does not consider the time value of money, and it does not take into account the timing of cash flow. Let’s say you want to develop a product and requires an initial investment of $100,000, but the investment doesn’t yield any revenue until the third year. You would need to be able to withstand the first two years without any positive cash flow from the project. The timing of cash flow is a critical aspect of any investment project.
3. Net present value
Net present value (NPV) is simply taking the future stream of cash flow and discounting them back to the present day so you can decide how much you would pay to obtain that stream of cash flow. It is calculated as the difference between today’s value of the projected cash flow minus the initial investment. If NPV is positive, you should consider investing in the project. Conversely if NPV is negative, the investment should be avoided because the initial cost of investment exceeds the projected return.
The major benefit of using NPV is that it accounts for time value of money and the timing of cash flow, which were the drawbacks of using payback period and ARR analysis. However, gauging an investment’s profitability with NPV relies heavily on the discount rate, which is determined by assuming the rate of return on an alternative investment.
Although the exact value of the project can only be known after its completion, NPV allows you to evaluate the investment in a project by accounting for time value of money.
Which method should you use?
Each of these methods has its benefits and limitations, so generally more than one is used for any given project. Although NPV is the most reliable method, a qualitative assessment is equally important to evaluate the investment in a project. For example, a project may not have a desirable return, but you might decide to go forward with it anyway because of its impact on the business’s long-term plan.