So, what is an asset? Broadly speaking, an asset is anything you use to make money in your business. To grow your business, you’ll have to purchase additional assets over time. These purchases are referred to as capital investments.
Every company needs to analyze whether or not a certain capital investment is a smart decision. After all, you have a limited amount of cash you can use. If you need to use cash to buy an asset, you need to make it count. Consider these 4 ways to analyze the profitability of a capital investment.
A capital investment example
Take a look at the top of the spreadsheet. Assume that Riverside Jeans needs to buy new sewing machine to manufacture their jeans. The machine has a cost of $10,000 and a 6-year useful life. Riverside assumes a 5% rate of inflation.
Next, Riverside makes a judgment on the value of the machine. Specifically, the company determines that the new machine will increase their cash inflows by $2,000 per year. That $2,000 increase is achieved, because the new machine can produce more jeans and will require less maintenance than the machine they’re replacing.
Cash flow analysis
The left column of the analysis shows each year. The inflow (outflow) column lists the cash impact of the new machine. In year 0 (today), Riverside writes a check for $10,000. That’s a cash outflow. In years 1 through 6, the machine generates cash inflows of $2,000 each year. That $2,000 is the increase (improvement) in cash flow each year.
The present value concept
The third column is titled “present value table”. Present value refers to the fact that payments in future years are worth less, due to inflation. Inflation is defined as the overall increase in prices over time. If someone commits to pay you $100 5 years from today, for example, those dollars will not buy $100 worth of goods 5 years from now.
Riverside uses the present value table for a 5% inflation rate. You can find these tables online. The table provides a present value factor, which is posted in the spreadsheet for each year.
Notice the trend with the present value factors. The further you go out in time, the present value factor gets smaller. That should make sense, because inflation makes each dollar worth less as you go from year to year. So, the present value factor for year one .952, while the factor for year 5 is .784.
Method #1: Present value of cash flows
The column on the far right is the cash flow multiplied by the present value factor. You’ll notice that the year 0 (today) factor is 1.
When you add up the present value of cash inflow and outflows, the net present value total is $152. If that number is positive, you should make the investment- you’re better off. When the sum of the cash flows is negative, you should not make the investment.
#2 Payback period
Obviously, your first priority when you make a capital investment is to generate enough cash flow to recoup your original investment. Think of that concept when you consider payback period.
Payback period is defined as (Original investment) / (Annual cash inflows). For the Riverside example, the payback period is ($10,000) / ($2,000) = 5 years. You’ll note, however, the payback period does not apply present value to the cash flows. That $2,000 cash inflow in the denominator isn’t completely accurate, because each inflow is not adjusted for inflation.
Payback period is a quick way to analyze a capital investment, but it does not adjust cash flow to their present value.
#3 Accounting rate of return
A formula that is similar to payback period is accounting rate of return (ARR). This formula is (Average annual cash inflow) / (Total cash outflows). Riverside’s ARR is ($2,000) / ($10,000), or 20%. The formula tells you that, on average, you’ll recover 20% of your original investment each year.
The ARR formula does not adjust average annual cash inflow using present value factors.
Uneven annual payments
It’s probably more likely that the cash flow increases will be uneven. Just below the accounting rate of return formula, you see a cash flow analysis with uneven payments. Note that the average of the annual cash inflows is $2,000.
The format is the same. You’ll see a column for years and a column for the cash inflows and outflows. Each cash flow is adjusted, using the same present value factors (5%).
This schedule indicates that more payments come in the later years. That means that the larger payments are multiplied by a smaller present value factor. The $4,000 in year 6, for example, uses the 0.746 present value factor.
The net present value of the cash flows is ($2,048). Since the total is negative, Riverside should not make the investment.
The prior two cash flow examples used an inflation rate of 5%. Instead of an inflation rate, you can think of the rate as a desired rate of return. Investors use the term discount rate for that rate of return.
Every business owner has limited resources. One way to successfully manage a business is to make smart choices about using your resources. You can use a discount rate to make those decisions.
Say, for example, that you’re considering buying the new machine or investing in another business. One of your denim suppliers needs additional financing, and you’re considering making an investment.
OK- how to you decide how to use your resources? Assume that you expect a 7% annual return from the investment in the supplier’s company. Any other use of resources would have to provide a return of at least 7%. If not, you’d simply invest in the supplier.
7% should be the discount rate you use in any cash flow analysis.
#4 Internal rate of return
Internal rate of return (IRR) is a tool used to measure the profitability of a capital investment. IRR calculates the discount rate that makes the net present value of the cash flows equal to zero.
Assume that you apply a 7% discount rate to a project. If the net present value is positive, you should pursue to project. A negative net present value means that you should pass on the project.
The easiest way to calculate IRR is to use a function in Excel. I’ve included the formula in the spreadsheet. The IRR for the uneven cash flow example is (11.9%). That makes sense, because the net present value of the cash flows is negative.
You’ll also note the IRR for the cash flow example with annual $2,000 cash flows. The IRR is 5.5%. If you scroll up to the top of the document, you’ll notice that an inflation rate of 5% generated positive net present value (NPV). The NPV was small, but it was a positive number. It makes sense that the IRR is slightly higher than 5%.
Use these four tools to make informed decisions about your capital investments. Successful companies get the most out of their limited resources. Try using these tools to select the right investments.