If you’re like most bigg goal-getters, you have a lot of ideas. But how do you know which ones you should invest in? That’s what we want to talk about today – project selection.
This process can be used for so many things. You could use it to decide if you should start a business. It would help figure out if you should expand your existing business. You could even use it to determine if it’s worth going back and getting more education.
To get started, you’ll need to make some projections, using assumptions, about the expected income and expenses of your project. The process itself is a science but the assumptions are definitely an art. It requires that you use your own judgment and the only way to learn how to do it is by doing it.
So let’s look at the two most common ways to determine if a project is worth doing.
As its name implies, this method simply looks at how quickly you get your investment back. So if you invest $100 now and earn $25 the first year and $75 the second year, you have a two-year payback.
Payback is commonly used because it’s so simple. But think about it … it ignores all the money you could make after the payback period. And that can really skew your investing decisions. You choose projects that return your investment quickly and neglect projects that may offer greater potential but more patience.
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Discounted cash flow (DCF)
Fortunately, there is a better way to calculate the worth of a project. With this method, you explicitly recognize that a dollar today is worth more than a dollar tomorrow. However, a dollar tomorrow is still worth something which isn’t recognized by the payback method.
It’s called discounted cash flow because we look at all of our expected cash flows and determine how much they’re worth right now by discounting them back to today. That is called the “net present value” (NPV).
Calculating the NPV is a four step process:
- Determine how much you will invest by year.
Usually most of your investment in a new project is made upfront (and probably in the first year). But if your project requires that you make an investment over a few years, you’ll want to account for that.
- Estimate how much income this project will generate by year.
Obviously, you don’t want to take on a project if it doesn’t increase your income. So look at how much you think you will make with this project and compare that to how much you think you plan to make without it. That’s your increased income from the project.
- Decide upon your opportunity cost.
Here’s where it gets a little tricky. Consider where you could invest your money if you didn’t invest it in this project. Weigh in how certain you are about your projections.
For example, if you determined your project was no more risky than investing in Certificates of Deposit at a FDIC-insured bank, you could use the interest paid on those accounts as your opportunity cost.
Most projects aren’t that certain so your rate will usually be higher than that. Just remember – the less certain you are about your incremental income, the higher your opportunity cost.
- Run the numbers in Microsoft Excel (or your favorite spreadsheet program) using the formula:
Example – Should I get certified?
We’ll offer an example so you can see this concept in action. Let’s say you want to go back to school to get certified. It costs $2,000 for the certification program. You expect to make an additional $2,000 a year if you do it. You plan to retire in three years so the increased income won’t benefit you for too long. You’ve looked at other opportunities and determined that you need to earn at least 6% on your money.
We see that your payback period is one year. That’s how long it will take to pay you back the money you invested.
Using DCF, your NPV is $3,157 as shown in this screenshot from Microsoft Excel:
To get that, use Excel’s “Insert Function” command:
With DCF, the rule is: If NPV > $0, then invest in the project. After all, your expected return exceeds your expected cost. So in this case, your NPV is over $3,000. Therefore, you should go for it!
If you want to know what your annual return is, just change the opportunity cost field in your spreadsheet until your NPV equals $0. In this case, your annual return is 83% over the life of the project.
In general, pick the projects with the highest NPV until you run out of money to invest. However, there is one important variable we failed to account for in this calculation – your time. We’ll discuss that tomorrow.
Thanks so much for stopping in to read our post today. Until next time, here’s to your bigg success!
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(Image in today's post by monetary 3D 2)