This is a question that many small business owners have. There are many issues that need to be addressed to find the answer but one of the big ones is how much will the expansion cost (the initial outlay) and how much cash (operating cash flows) will be generated. A tool to help evaluate whether the operating cash flows generate a return to justify the initial outlay is called Net Present Value (NPV).
NPV is a fundamental element of business finance and it is based on the concept of the time value of money. The time value of money suggests that a dollar is worth more the sooner it is received. To see how this works consider that you were offered the option of receiving $100 now or $100 in one year’s time. What would you choose?
The $100 now is always worth more than the $100 in one year’s time. If you wanted to spend the money you could do so now rather than waiting for a year. Alternatively if you did not want to spend it immediately you invest it for a year and earn some interest. If you did invest you would have more than $100 in one year’s time. Either way you are better off receiving the $100 now rather than waiting twelve months.
NPV is a tool that helps evaluate investment options when the numbers are more complex than the $100 example. However, it is still based on the concept that a dollar is worth more the sooner it is received.
For example, you are presented with an investment option whereby if you invest $20,000 now you will receive $2,000 in one year’s time and $22,000 in two years time. For investments of this kind you expect to get a 5% return. Should you go ahead with this investment? A quick answer to this question is, yes, the investment is good as you will receive $24,000 (2,000 + 22,000) and only outlay $20,000. However, that answer does not take into account the time value of money.
NPV is a tool that does take into account the time value of money. It does this by putting those three cash flows (the $20,000 outflow and the $2,000 and $22,000 inflows) in “today’s” dollars. What does that mean “today’s” dollars?
Remember that we said that $100 is worth more today than in one year’s time. NPV quantifies that by outlining what $100 in one year’s time is worth today. You require a 5% return on your investment so that means that the $100 is one year’s time is worth $95.24 ($100/1.05) in today’s dollars. In other words if you invested $95.24 today at your required return of 5% you would have $100 in one years time.
This NPV tool can be used to evaluate the $20,000 investment option produces the following result.
Year Cash Flow In Year Divide by Required Return Cash Flow in today’s dollars Now -20,000 -20,000
1 2,000 1.05 1,905 2 22,000 1.05 * 1.05 19,955 Total (NPV) 1,860
The rule is if the NPV is zero or positive it is a good investment. Note that we need to divide the year two cash flows by “1.05 * 1.05” because the $22,000 is received in two years time so to convert it to today’s dollars we need to allow for the required return over two years.
NPV and its relative the Internal Rate of Return (IRR) are important tools when evaluating investment options including deciding when to expand. However they are just part of the tool kit and need to be complemented by such things as:
Business Environment Analysis Industry Environment Analysis Sensitivity of Assumptions Analysis Marketing Plan Business Action Plan Skills Gap analysis Whether you do the NPV analysis yourself or you employ a financial expert to do it for you it is important to understand what the results mean so that you can make the most effective decisions.
When is the right time to expand? - To learn more about this author, visit Gerry Maguire's Website.
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