What is your company’s target rate of return on any capital invested? If you don’t know the answer, you may be spending money willy-nilly without any true guidelines about acceptable rates of returns. On the other hand, if you have targets, but aren’t using net present value analysis to make sure you are hitting the target each time you spend money, you are no better off than the marketer without a target!
First, let’s deal with setting targets. At an absolute minimum, consider that you can take cash into a bank and earn 5% with zero risk in a CD. So we know you better have a target greater than 5% if there is risk involved with your investment.
Next, consider that an average blue ship stock return runs about 12%. How risky is your project or business compared to the stock market? Most marketers realize they have a bit more risk than a typical blue chip company.
In practice, most energy companies presently use 15% to 18% for target rates of return on invested capital. Yes, that means that you don’t spend a dime unless you know you can get 15% to 18% return per year on those dollars.
The trouble with this thinking is that it still hasn’t taken into account the time value of money. If you spend $100,000 today knowing you’ll get an 15% return, the $15,000 you earn ten years from now isn’t really worth $15,000. Why? Because of inflation.
To test this theory, let’s pretend you were just told you won $15,000 cash. Next, You are given the choice of receiving the cash today, or receiving it ten years from today. Which option would you select?
Of course, you are no dummy. You’d opt to receive the money today! Intuitively, you knew the time value of money when you made that choice. Yet, when marketers spend money at their companies, they pretend that the $15,000 received in year 10 is just as valuable as the $15,000 received today when they analyze the return on a project. That’s obviously wrong.
The worksheet below will allow you to determine if any project meets a target rate of return of 15%. The discount factor line shows the reduced value of each $1 over time that could have been earning 15%.
To use this worksheet for capital spending decisions, first determine the cash inflows and outflows for the project. For instance, cash outflows might be a down payment required and then loan payments made each year.
Next, determine the inflows for the project. This is profit before depreciation or any other non-cash items. (Note that if you account for loan interest in the outflows, don’t double dip yourself when you calculate your project’s net profit. Use the net profit before interest.)
The third row down is just the net cash difference between the inflows and the outflows. (Hopefully, in all but the down payment period, the inflows are more than the outflows for a positive net!)
Next, multiply the net times the discount factor in the worksheet to calculate the net present value for each year. By summing the bottom line for each of the eleven years, you’ll have the true net present value of your project in today’s dollars, assuming a target investment rate of 15%. As long as the sum of the numbers is positive, you have a project that meets your investment criteria!
Be sure when you use this model that you account for the disposal (sale) of the asset no later than the tenth year. If you were determining the feasibility of a project involving real estate, and let’s say you borrowed on a 30 year mortgage for that real estate, you would need to “pretend” you sell the property in year ten. Therefore, put the total amount of the loan balance in the outflow and the sale proceeds in the inflow.
Sometimes users of this model feel uncomfortable guessing about the value of their property in ten years. You’ll note that in ten years, the discount factor is less than 25%, so you truly have some room for error without making large differences in your net result!
