Making Capital Investment Decisions Using NPV, IRR, or payback method
Consider these ten things when you're using the NPV, IRR, or payback method to make a capital budgeting or investment decision.
1. Remember that the reason you're making a capital budgeting decision is to create more value in the future than exists today! Don't commit yourself to a future course of action that is not profitable in the future under all possible conditions you can think of today and expect tomorrow. The value of a decision is not only centered in its expected results, but it is raised or lowered according to the number of decisions in the future that it does not preclude, but allows , and those for which space is created. This statement has profound meaning for the futurity of decisions and the design of decisions by decision makers!
2. Always use cash flows and not accounting income to create your investment decision. Cash flows are the result of the total effects of implementing the project or investment scenario only AFTER all costs are removed!
3. Do not include sunk costs in your investment analysis. They are already spent, gone, kaput; use only the costs that will be incurred by the new project or investment. There will be a tendency to--see how much we've already invested--use sunk costs to justify going ahead with the project anyway--DON'T! It would be irrational to use past expenditures to consider a decision which can only affect the future!
4. You must consider "opportunity costs" as costs of the project or investment. If you use something that could be used for something else, the cost to replace the use of the something else must be included in your capital budgeting analysis. Always consider alternative uses of capital and resources as costs to the capital budgeting project or investment.
5. Look beyond. You must consider not just the first order of consequences, but the orders of consequences following your project decision. Build a scenario of contingencies given the project decision. Look at the downstream effects of the decision, what are the side effects? Are there hidden costs, if so add them to the decision. Will the project steal market share from ongoing investments? What is the expected effect of these losses?
6. What are the effects of the non-conformities. Don't let the assumptions you make about the present and the future be "blinding." In the world we live in today, things change--overnight! What about the nonconforming assumptions you make? How flexible are the beliefs that you have established the project parameters upon? Accounting for this now, will keep the value of the project in real terms.
7. Part of the reason that NPV calculations come out the way they do is because of IRR or Internal Rate of Return. IRR is designed to calculate the "discount" rate at which the cash flows of your project are discounted. Make sure that the IRR, discount rate, hurdle rate and the project discounting rate are sufficiently related or indexed to the market environment. If you used a discount rate of 5% and the real rate of inflation soared to 10% during the project--which happened in the early eighties--your project assumptions could create disaster for the company or your investment. Don't just assume that because you have an IRR of x% that you should use that % to discount cash flows under NPV calculations.
8. Consider the utility of time not just the time value of money. With change occurring so rapidly, how quickly you get to the marketplace often determines how much utility is available for your investment decisions. It is extremely difficult to calculate the utility of ideas--often the marketplace is the only valuing entity--but as a planner you must gain a feel for what happens if you're not first, your project is outdated before you go online, or sudden shifts in macroeconomic factors change project assumptions. THERE AREN'T ANY GUARANTEES--BUT, he who ventures forth blindly, even though with courage and certainty, may need a parachute!
9. Consider risk management, contingency planning and disaster recovery as a cost of the project! Risk analysis, business interruption and disaster recovery are important factors when considering the ultimate cost or discountability of cash flows. What is the risk level of the project or investment? How can this "cost" be factored into the calculation? If the project is a complete failure, is wiped out by unforeseen contingencies or even hampered by personnel problems, what will be the effect on the company, organization or investment?
10. Last, but not least, a maxim from Professor Sharpe at Standford University who says, " it is important to remember that investment opportunities may influence one's consumption decision and that consumption opportunities may influence one's investment decision." GOOD LUCK!
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