The conventional way of calculating ROI has some limitations. For one thing, it doesn’t provide an accurate economic picture of the organization. That’s because it ignores the time value of money, that is the notion that any money received now is worth more than it would be worth in the future.
Also, ROI reflects the rate of return over the life of the investment, not the annual rate of return. This is a problem because you can’t analyze it in terms of annual costs and thus easily compare it with other annual returns.
Therefore in order to compensate for these limitations, you can use a method called net present value(NPV) analysis. NPV is more sophisticated because it takes into account the time value of money.
Time value of money
The time value of money principle states that a dollar you receive five years from now is worth less than a dollar you receive today. The reason: even assuming no inflation or risk, the dollar you get today can be invested somewhere. Assuming a positive return on that investment, that means you’d be able to earn more than a dollar by the fifth year.
When you’re evaluating a potential investment, you need to analyze the income you expect that investment to provide at some point in the future (n). But to do that, you have to express future dollars in terms of current dollars.
Net present value (NPV) and internal rate of return (IRR) calculations help you do that.
These analytical methods are fairly complicated. But most calculators, apps, and spreadsheet programs can make these computations for you easily.
Discount future income
To reflect the time value of money, you have to discount future cash so it’s expressed accurately in today’s dollars. Simply put, a $100 savings today will not be $100 savings five years from now.
While you can use a calculator or app to calculate NPV, you need to supply the values. An NPV calculation determines the net present value of a series of cash flows according to the following algebraic formula:
In this formula:
- Each CF is a future cash flow, so CF1 = cash flow in the first year
- n is the number of years over which the cash flow stream is expected to occur
- i is the desired rate of return, or the discount rate
The discount rate in the context of financial analysis means the interest rate earned. In the United States, it refers to the rate at which banks can borrow short-term funds from the Federal Reserve Bank, and is used as a conservative proxy for the cost of funds.
In analyzing an investment, the discount rate is any market interest rate for a “riskless” asset, for example, a Treasury bill, note, or bond, whose maturity matches the investment’s time frame. For a shorter-term investment, an organization might use the rate on a Treasury bill (whose term is under one year). For a longer-term investment, it might opt for the rate on a Treasury note or bond, whose terms run 2-10 years. As a rule, the higher the discount rate, the lower the NPV, all else being equal.
Some organizations ignore the market discount rate and stick with a theoretical or historical discount for analyzing potential investments. Others use the weighted average cost of capital which averages the return of a stock, debt, and preferred stock instead. This option is sometimes used by larger organizations that issue stock.
Another option is using the rate of return for alternative investments.
Finally, consider the element of risk. A riskier investment should have a higher discount rate than a safe investment. Similarly, a longer-term investment should use a higher discount rate than a short-term project.
When you supply the values for each future cash flow, the discount rate, and the number of years, your spreadsheet, app, or calculator will do the rest.
If the NPV of an investment is a positive number, and no other investments are under consideration, the company would do well to pursue the investment. If it’s less than zero, the company should reject the investment. If it equals zero, it’s marginal, therefore, a judgment call.
NPV > 1 (GO)
NPV < 1 (NO GO)
NPV = 1 (MARGINAL)
In considering whether to invest in a new line of serving carts, KJTL assumes a discount rate of 6%. (Surveys show that the discount rate used by companies today varies greatly, from 3% to as much as 7%.) Plugging in the additional data for the calculation—the initial costs and expected returns—yields an NPV of $2,742 for the new line. This NPV is positive, so it suggests that the new line could be an attractive investment for KJTL.
But what about KJTL’s other possible investment , the $100,000 production-line robot? At a discount rate of 6%, the NPV for this investment is $483, which is just barely positive.
If KJTL can afford to make only one of these two investments, it should go with the new serving cart line, because the NPV is much greater.
Companies often purposely set the bar to investment high. So, what would happen if you assumed a discount rate of a more conservative 10% instead of 6% for KJTL? (A discount rate of 10% these days is very high, but is used here for the sake of illustration.) The NPV for the serving carts would be MYR –22,553; for the robot, MYR –$12,368. The serving carts were a better investment than the robot at 6%. At 10%, both investments are bad, but the serving carts are worse. This shows just how much the picture changes when a different discount rate is assumed.