Net Present Value Analysis
Q. I’m trying to decide whether or not to invest a large amount of money in new technology that will lower our production costs. A newly minted MBA I just hired has completed something he calls a Net Present Value analysis. He says that the NPV is positive, so we should make the investment. I’m not really sure what he is doing. Do you have any advice?
A. First, we commend your new employee. A Net Present Value analysis is exactly the right way to assess a project that requires a cash outlay upfront to achieve lower costs going forward. Here’s what he is doing.
The negative cash flow happens now. You have to buy the new technology. The positive cash flow happens in the future. You reduce production costs. However, a dollar a year from now is not worth as much as a dollar today. There is a cost associated with having your cash tied up for a year. It’s called the 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. Let’s say your cost of capital is 15 percent. A dollar today would be the same as $1.15 a year from now because you could invest the dollar now at 15% and have $1.15 in 12 months.
Your new employee is taking all of the positive cash flows that he expects to happen in the future and discounting them to put them in today’s dollars so that he can compare the positive cash flows to the negative cash flows. In the example above, he would divide cash flows that happen a year from now by 1.15. Cash flows that happen two years from now would be divided by 1.32 (1.152). Cash flows that happen three years from now would be divided by 1.52 (1.153). You see the pattern. Once all cash flows have been discounted to today’s dollars, he adds them together. Theoretically, if the sum is greater than zero, the project has a positive NPV and should be pursued.
Your new employee has employed the proper analytic technique. Unfortunately, good analysis, by itself, rarely gives you the answer to a business problem. Rather, it allows you to identify those 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 to have your new hire perform a sensitivity analysis on the critical assumptions that lie behind his work. Would the answer change if each variable were a bit larger or a bit smaller? Assumptions you should test 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 comes along in five years that makes your purchase obsolete, a 10 year time horizon is too long. Suppose your time horizon were shorter. What impact will that have on the analysis?
Terminal value – How much is the technology assumed to be worth at the end of the time horizon? Perhaps you can sell it, but it may be worth no more than scrap value. In fact, you may have to pay to have it removed. Test the assumptions about terminal value.
Discount rate – Does the discount rate used in the analysis reflect your true cost of capital? If your discount rate is actually higher than assumed, the future positive cash flows will be worth less today. Make sure you understand the sensitivity to the discount rate that was used in the analysis.
Once you understand how sensitive the answer is to these variables, you can apply your business judgment to determine whether or not to proceed. We don’t know the details of your situation, but in many analyses of this type, the critical variable is sales volume.
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. By the way, with your years of experience, you are much better positioned to make this judgment call than any newly minted MBA.
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 business, analysis can be powerful, but it rarely gives you the answer. Rather, it helps you understand where to apply business judgment. Good luck with your decision.