Alphabet Finance: How To Calculate The Return On A Business Investment

You have a plan to strategically invest your business capital

. You want growth in sales and value for your company and you have identified one or more opportunities to deploy your company's cash and accomplish your business objectives. How can you identify the most financially attractive investment? Make the right choice and your business will bloom with new revenue and added value. Make the wrong choice and you will spend years untangling from an unwise investment and incurring substantial financial losses.

There are three primary methods of evaluating the financial return of a capital investment. You can look at a static or pro forma return on investment (ROI), an internal rate of return (IRR) or the net present value (NPV) of an investment. Actually, you can use all three methods to have a more complete financial picture. There are other less useful but widely used methods to evaluate the return on an investment such as calculating the payback period. This article will look at the three most useful methods previously mentioned.

The easiest and most common method to evaluate a business investment is by calculating a static pro forma return on investment (ROI). The word pro forma comes from the sixteenth century Latin word meaning as a matter of form. The pro forma return calculation looks at what will be when the investment is fully operational or stabilized. This calculation ignores the planned ramp up period for the strategic investment but takes into account any operating capacity slack at stabilization. Time value of money is not a consideration in the pro forma ROI calculation. In other words, if it takes several years after you make the investment to begin generating profit there is no discount for the delay in investment return. Time value of money is a financial principle that a dollar today is worth more than a dollar tomorrow due to expected or realized inflation. To calculate a static ROI simply take the expected stabilized net operating income divided by the expected costs to acquire and improve the investment. You can evaluate competing capital investment opportunities using ROI because all the calculations are made using dollars at today's value.

The Internal Rate of Return (IRR) calculation takes into account the time value of money. As mentioned above, time value of money is a financial principle that a dollar today is worth more than a dollar tomorrow due to expected or realized inflation. In other words the longer you have to wait for an investment to return a dollar the less it is worth to you today. The IRR calculation takes a series of investment inflows and capital outflows and returns the average annual rate of return over the investment period to yield a zero net present value (NPV, see below). For example, an investment that has a ten-year time horizon might return a 10% IRR which is the average annual return of the investment. Some years the return will be higher and some years it will be lower. IRR is useful for comparing strategic investments that have the same time horizon but different planned cash flow streams. It also provides clarity because it discounts future cash flow.

Net Present Value (NPV) is the cousin of IRR. The differences are with IRR you solve for the average annual return to get a zero NPV while the NPV calculation shows the value in today's dollars from a series of future investment flows. You need to determine the annual discount rate to solve for the net present value for your investment opportunity. This involves substantial guesswork and is prone to error so be careful when selecting the discount rate to apply to future cash flows.

The last word is about positive and negative leverage. You should evaluate an investment on an un-leveraged basis first, that is before considering any debt financing. Loans add an extra layer of complexity with multiple variables subject to market forces outside of your control. An investment that has a rate of return greater than the expected loan interest rate generates positive leverage. If the return on investment is less than the loan rate then you have a negative leverage situation. Leverage is a double-edged sword with a positive edge that will help you conquer your business goals and a negative edge that will hack your company to pieces.

Choose carefully from among your investment options during your financial planning process. You have a finite amount of disposable cash for growth opportunities. Your strategic investment plan should include a calculation of return on investment (ROI), net present value (NPV), and internal rate of return (IRR) for each business opportunity.

by: Michael Shelton

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