How to Use Net Present Value Analysis
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We recently helped a client think through whether or not to invest in new technology to reduce the cost of doing business. Specifically, the client wanted to reduce production costs.
To help the client think this through, we completed a net present value (NPV) analysis. A net present value analysis assesses a project that requires a cash outlay up front to achieve lower costs going forward. Here’s how it works . . .
Negative cash flows happen now. So, say you're the client that that negative cash flow is about to happen to.
Specifically, you have to buy the new technology; the positive cash flow will happen in the future. For that reason, you reduce production costs. However, a year from now, a dollar will not be worth as much as a dollar today; there is a cost associated with having your cash tied up for a year.
The term for this is cost of capital. For example, you may have to borrow the money and pay interest, or you may have to forego other projects that would have had a positive return. Consider that your cost of capital is 15 percent. A dollar today will be the same as $1.15 a year from now.
To complete the analysis, we take all of the positive cash flows that we expect to happen in the future and discount them, to put them in today’s dollars, so that your (the client) company can compare the positive cash flows to the negative cash flows. In the example above, we divided cash flows that would happen a year from now by 1.15. Cash flows that would happen two years from now would be divided by 1.32 (1.152). Cash flows that would happen three years from now would be divided by 1.52 (1.153) -- you see the pattern.
Then, once all cash flows had been discounted to today’s dollars, we would add them together. If the sum was greater than zero, theoretically your project would have a positive NPV and should be pursued.
Unfortunately, good analysis alone rarely provides the answer to a business problem. Rather, it allows you, the businessperson, to identify the critical factors to which the decision is sensitive, so that you can focus your business judgment on the things that matter the most.
Our suggestion would be for you to perform a sensitivity analysis on the critical assumptions in the analysis. Might the answer change if each variable was a bit larger or a bit smaller? Assumptions you should test would include:
- Production volume -- There is an assumption about the volume the new technology will be required to produce that will be determined by your sales. How much lower would sales have to be to cause this to be a bad investment (i.e., cause the NPV to be negative)?
- Cost savings – The analysis assumes that your costs will be reduced, but suppose you don’t realize all of these savings? How much lower would annual savings have to be to cause the NPV to become negative?
- Price -- There will be an assumption about how much you will get for your product. What happens if the price changes? Is this likely?
- Time horizon -- The analysis will have an end date (perhaps 10 years from now). If new technology could come along in five years that will make your purchase obsolete, a 10-year time horizon is too long.
- Terminal value -- How much is the technology assumed to be worth at the end of the time horizon? Perhaps you could sell it, but it may be worth no more than scrap value. In fact, you may have to pay to have it removed.
- Discount rate -- Does the discount rate used in the analysis reflect your true cost of capital?
In the case we cite, we worked with the client to understand how sensitive the answers were to these variables. This helped the client apply business judgment to determine whether to proceed. If you plan to apply NPV analysis to a particular situation, play close attention to sales volume. In many analyses of this type, sales volume is the critical variable.
For example, the sensitivity analysis may show that if unit sales grow at 10 percent per year or more, the investment is a good one. If sales grow less than that, the new technology isn’t a good investment. You can then apply your judgment to determine how much you think sales will grow.
In some cases, there are strategic reasons that compel the investment regardless of the result of any analysis. For example, if the market price for the product you sell is likely to drop below your current production costs, you’ll be forced to invest in the new technology or get out of the business.
In the end, business, analysis can be powerful, but it rarely gives you the whole answer. Rather, what it can do is help you understand where to apply business judgment, to know exactly where you stand.