Finance Basics (HBR 20-Minute Manager Series) (20 Minute Manager) by Harvard Business Review

Author:Harvard Business Review [Review, Harvard Business]
Language: eng
Format: epub, azw3
Publisher: Harvard Business Review Press
Published: 2014-02-17T18:30:00+00:00

TABLE 1

Net present value and internal rate of return

Net present value (NPV) and internal rate of return (IRR) are highly valuable analytical tools, but they can be fairly complex. Because most calculators and spreadsheet programs can do the calculations for you, we’ll describe these tools in broad terms only.

Consider the principle that underlies both methods: the time value of money. This principle states that a dollar you receive today is worth more than a dollar you expect to receive in the future. The reason: Even forgetting about inflation, you can spend or invest today’s dollar right away. You can’t do that with a future dollar. And every dollar you expect in the future comes with some degree of risk. For example, the person or institution that promised it to you may be unable to pay when the time comes.

But you can’t evaluate a new business opportunity without figuring out the value of the money you expect it to generate. So you need a method for expressing future dollars in terms of current dollars. That’s what NPV and IRR calculations allow you to do.

Suppose that Amalgamated expects a new line of coatracks to generate $60,000 in cash annually, beginning one year from now and continuing for five years. Here are the key questions to consider: Given this anticipated cash flow and the $250,000 in upfront costs, is a new line of coatracks the most productive way to invest that $250,000? Or would Amalgamated be better off investing its money in the extruder or something else?

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