Timing is Money

All spending must be expected to bring in more than goes out or there is no reason for doing it. Last month I talked about the simple payback method of cost-benefit analysis. Simplicity is both the strength and the weakness of payback. Payback assumes that cash flows, in and out, will be consistent. They seldom are. A project may require a big cash outlay at the beginning, to buy a line for example, followed by a smaller outflow the first years, due to introduction costs and low volume. Then, in subsequent years, positive cash flow is expected to increase as sales take off. Payback does not handle this situation well.

Another issue is the time value of money. A dollar today is worth more than a dollar a year from now. Terrific revenues 10 years from now may not offset negative or small revenue flows in the early years.

More sophisticated analysis must be applied to fine tune the project’s profitability. Two common methods are Net Present Value (NPV) and Internal Rate of Return (IRR). They are essentially the same except that in NPV the interest rate, more accurately the cost of capital, is a given and the analysis yields the net present value of the investment. IRR takes the cash in and outflows and solves for an interest rate. The main advantage of NPV over IRR used to be that it was easier to calculate. Now, spreadsheets like MS-Excel, make both simple. IRR has the advantage of giving a percentage rate of return that is easily compared to a company hurdle or to other potential investments. The choice is usually a matter of company policy.

Whichever method is used, good results depend on good data. All inflows and outflows must be identified as accurately as possible. This is usually the hardest part. Once that is done, it is basically just plug and play.

Time is money and so is timing. It is almost as important to financial decisions to know when cash will flow as it is to know how much.

My book, Secrets of Buying Packaging Machinery with John Henry is available on Amazon has much more information on project financial analysis. Call us 630-629-9900 and we’ll help you figure out your best options.