Admit it. In the face of more tactical accounting issues, you’ve found yourself out of practice with NPV (Net Present Value) and IRR (Internal Rate of Return) applications. To help jog your memory, we’re offering a quick refresher on the key differences between the methods – what you are measuring and why – as well as general scenarios in which one method is more advantageous than another.
Dusting Off Your Financial Toolkit
As a finance professional, you are engaged in – if not responsible for – capital budgeting for your firm. In order to compare and prioritize investments like equipment, technology, or even an acquisition, you likely use 1 of 3 financial formulas: payback method, NPR, and IRR. While the payback method is easy to calculate and understand – determining when you’ll make back the money invested – it doesn’t account for the future value of money.
NPV is a highly effective gauge for companies using “today’s dollars for future returns” and, thanks to Excel, it’s easy to calculate. [Harvard Business Review]
NPV= ∑ [Period Cash Flow / (1+R)^T] – Initial Investment
R is the discount rate and T is the number of time periods. [Investopedia]
Say the purposed investment is expected to yield 5 years of returns. First, determine the future returns by using a discount rate (or interest rate) that adjusts for today’s dollar value and projects annual cash flow across the 5 years of the initiative. The discount rate will be specific to your organization and the type of funding used for the investment, either through commercial borrowing or investors. (Note: Evaluating different discount rates as part of a sensitivity analysis allows you to consider variabilities in the face interest rate or other market fluctuations.) Next, subtract the cost of the investment itself. If the NPV is negative, then the project will be a cash drain and shouldn’t be pursued. If it’s positive, consider moving forward. The larger the NPV, the greater the benefit the investment brings to your company. [The Strategic CFO]
IRR also measures the profitability of potential investments, using the same formula factors as NPV. To calculate IRR, set NPV to zero. Now calculate the rate at which the capital investment made is equal to the cash inflows received. Per this calculation, IRR is expressed as the expected percentage return, whereas NPV provides actual cash returns in today’s dollars. IRR also doesn’t lend itself to the same sensitivity analysis as NPV, either with varying discount rates or changing cash flows, making it a more static and less nuanced metric. Given that it’s measuring a rate of return, IRR will calculate more favorably against shorter duration projects, even if a longer-term initiative with slow-but-steady returns is ultimately more valuable to your organization. However, its advantage is its simplicity; returns stated as percentages can be easier to understand and compare to the required cost of capital. [The Strategic CFO] But users beware: IRR is significantly less effective when comparing investment opportunities with different timeline and cost requirements than it is when evaluating a single project. For best results, use IRR in conjunction with NPV for a fuller picture of potential performance.
Putting it in Practice
Navitance has recently been working with a nonprofit client to evaluate the cash flow merits of a strategic budgeting decision using NPV. The question at hand is whether to pay off a 20 year mortgage, on which 15 years remains. Using a best use of funds analysis in complement with NPV, we have presented two scenarios:
- Pay off the $1 million note and associated fee for early loan termination
- Manage the cost over the next decade and a half of debt service, as evaluated in today’s dollars
This strategic application of NPV has provided the nonprofit and its board with a clear understanding of their options, associated coverage ratios, and impacts.
With the first quarter nearly behind us, you may still be wrestling with capital budgeting priorities and might benefit from a 3rd party perspective. To discuss investment prioritization in the context of business strategy and expected yield, don’t hesitate to contact me at firstname.lastname@example.org.