Creating financial models is always a bit of gamble amid lines of spreadsheet formulas. For managers who don’t come from a financial background, the exercise can seem daunting from a distance.
The good news: many risk professionals have trod this path before you. Learning to use standard modeling tools and to account for uncertainty in your projections will pay dividends far into your career
Plan to run your numbers through at least three formulas. The calculations are named Net Present Value, Internal Rate of Return, and Payback Method.
(NPV) Net Present Value
Net present value (NPV) compares the amount you’ll invest today with the current value of the future cash receipts from your investment. Remember, a dollar spent today is worth more than a dollar spent or earned next year, because inflation erodes the value of money over time.
Calculating the NPV of an investment helps you and your board decide which investments are worth doing. An investment needs, at minimum, a positive net present value to be worth the expense. So not only must a project that costs $100 today return $100 at some point in the future; it must return $100 plus whatever value has eroded over that time.
To figure NPV, start with the amount of the initial investment and the cash flow it will produce (either in added profits or reduced costs). Say you want to pay $100,000 for a four-year subscription to a due diligence service. It will save $30,000 each year since you can cancel other providers.
So far, so good. Next you need to know the discount rate your board applies for investments: the rate at which the value of a dollar erodes. Discount rates vary by industry and company, and usually they are somewhere near the company’s cost of capital — what the company pays to borrow money. Your corporate finance department can give you a good discount rate to use.
In our example above, let’s say the discount rate is 10 percent. Take that rate, the $100,000 investment, and the $30,000 in annual savings, and enter them into one of Excel’s NPV formulas or an online calculator. You’ll find that after four years this investment produces a net present value of negative $4,904. That means it is a no-go.
What then? You could try to negotiate the price of the subscription. Start by entering different projections into your NPV calculator, to see what works for you. For example, bargaining the vendor down to $90,000 leads to a positive NPV of $5,096 after four years. The board will like that better.
(IRR) Internal Rate of Return
Internal rate of return (IRR) shows the interest rate produced by an investment with payments and income occurring at regular intervals. IRR lets you compare your proposed investment to the desired rate of return, and compare different investments.
You can figure IRR with various Excel formulas and calculators. The inputs are tricky, because you need to estimate the initial investment as well as the annual discounted future cash flows. If you don’t have much experience with corporate finance and modeling, you may want to enlist the help of someone in the finance or accounting departments.
IRR should exceed the minimum corporate return rate — also called the hurdle rate — if you expect to sell the idea to your board.
For example, say you want a $500,000 computer system to manage risk. Each year it should produce $160,000 in profits or savings. After four years, it will be obsolete and sold at salvage for $50,000. If you discount the cash impact every year with a hurdle rate of 8 percent, you’ll realize $141,247 the first year, declining to $26,808 (the discounted $50,000 salvage price) the fifth year.
This produces an IRR of 13 percent. That’s above the hurdle rate of 8 percent, so the idea is a positive one you can pitch to the board. You can also compare that 13 percent IRR to other investments to see which one is best.
IRR is not foolproof. A small investment with a high IRR can be less worthwhile than a bigger investment with a lower IRR, because the larger project saves more dollars. Also consider your company’s special needs, risk tolerance and other options; your board may ask about them.
Payback Period Analysis
Payback period analysis (also commonly known as the payback method) tells you how many years an investment will need to pay for itself. The payback period can be determined with any standard calculator: just divide net annual cash inflow by the required investment.
Say you want $20,000 for an online training system. In 10 years it will be obsolete, with zero salvage value. Each year you use it, you’ll save an estimated $10,000 in travel costs. Dividing $20,000 by $10,000 gives 2. That is the payback period in years.
Payback period analysis is harder with more complex situations, such as investments that keep producing cash flows after the investment’s useful life. It’s good for comparing projects with varying payback periods, especially when money is tight. Your board may also have a maximum allowable payback period. You’ll want to know this before making your pitch.