If you use a traditional return on investment to make project decisions, you are missing a critical factor for your decision – the time value of money.
Traditional return on investment models simply average the annual net profit expected on the investment and then compare that average profit to the cost of the project for a percentage return. The flaw in that method is that one dollar profit received five years from now has nowhere near the value of one dollar received today.
The only way to calculate the true value of a project is by using discounted cash flow, also known as net present value — the only project evaluation method to take the time value of money into consideration.
Why is money received in a future period worth less than money received today? There are basically two reasons: inflation and the opportunity cost or what that money could have been earning for you if you received it today.
If someone gave you one dollar today, you know with absolute certainty that you could make at least 5% on that dollar without any risk by putting it in a bank CD. Of course, you would also have other options for that money that might entail some risk, but provide you with a greater return.
A sampling of discount rates is shown in the table. Notice that $1,000 received ten years from today is worth only $247 in today’s dollars if that money could have been put in an investment earning 15% per year.
So now let’s bring this time value of money concept back to project decisions. For each project that requires capital, apply this concept to the annual cash flows to see if your project is a winner.
To analyze the net present value of the cash flows or feasibility of any project, we need the following information:
1) The price of the project.
2) The down payment and any financing terms.
3) The annual net profits for the project before depreciation.
4) Any residual value for the project.
Because projections beyond ten years lose a great deal of validity, we will confine our analysis to a ten-year time frame. For any project that produces cash flow for more than ten years, we will assume we liquidate the project at the end of the tenth year.
For each yearly time period from now (which we call the down payment time) through ten years, we will need the following three pieces of information:
1) Cash Outflow – This is typically the project cost, which may be split into a down payment and loan payments thereafter. If the project extends beyond ten years, any loan balance at the end of year ten is assumed to be paid in full.
2) Cash Inflow – This is your bottom-line before depreciation and any loan expense.
3) Discount Factor – Based on the specific opportunity cost percentage you select, a discount factor will be applied to the net cash (Cash Inflow minus Cash Outflow) for each period. Discount factors may be calculated using a financial calculator, or obtained from any financial textbook.
To determine which discount factor to apply, think about the risk in the project. The greater the risk, the higher return you should expect and therefore the higher the discount factor. Most petroleum companies use a 15% discount factor when analyzing potential projects.
Let’s see how the method works in a practical wholesale application.
Example – You want to determine the feasibility of branding a gasoline retailer who sells 60,000 gallons per month. To consummate a seven-year contract where you will earn five cents per gallon, the dealer asks you to invest $150,000 in site upgrades. Your major supplier will help underwrite your costs through either a two-cent, four-year per-gallon rebate (a total of $57,600), or $50,000 cash up front. You analyze your options as follows:
Option 1: Down payment – $100,000 (your $150,000 less the $50,000 reimbursement).
Cash inflow – $36,000 per year net profit after freight for seven years.
Cash outflow – None
Option 2: Down payment $150,000.
Cash Inflow: $50,400 per year for four years, then $36,000 per year through year seven.
Using a 15% discount factor, we find the net present cash value of option 1 to be $49,726. This means we have met our 15% hurdle plus have another $49,726 to boot.
For option 2, we find a cash value of $40,922. This option also produces returns in excess of your 15% hurdle rate, but because the rebate is spread over a four-year time span, the $57,600 in rebates is actually worth less than the $50,000 cash up front due to the time cost of money.
In summary, at Meridian we highly recommend the use of discounted cash flow for analyis of any capital expenditure. Whenever you contemplate spending money for anything (buying a store, tanks, another marketer, etc.), take a minute to run a discounted cash flow analysis to be sure you’re making a wise, economically viable decision with your hard-earned cash.