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Is Your Project Worth Your Money?

money 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.

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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.

Payback period

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:

NPV 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:

Microsoft Excel set up screen shot

To get that, use Excel’s “Insert Function” command:

Microsoft Excel insert formula command screen shot

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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A Wii Bit of Fun

employee Our friends Paul and Stephanie bought a Nintendo Wii not long ago. They invited us to their home recently and we played games. It was so much fun! It was great to hang out with good friends. And we got a work out!

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We boxed, played tennis, took in a few rounds of golf, and did some bowling. It was a blast!

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george
For the record, Mary-Lynn kicked my you-know-what when we boxed.

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A small investment leads to bigg fun

Part of the reason our friends bought the Wii is that they have a wee little girl. So they don’t get out as much as they used to. They made a small investment in this game system. They get to have some fun, and some couple time, when little Ellie goes to sleep. And whenever they have friends over, everyone can join in the fun!

We’re not bigg gamers, but this was really a blast. There may be a Wii in our future. It’s definitely an investment – by the time you buy all the accessories – but you can entertain yourself at home instead of going out and spending money.

It doesn’t require any investment

Our local movie theater has an air hockey table. So whenever we go see a movie, we play some air hockey. And to let you in on a little secret, sometimes we don’t go to the movie!

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marylynn We’re both pretty competitive. The puck often flies off the table! The sad thing is, what really gets my goat, I have yet to win an air hockey match against George. I don’t understand because I’m pretty good!

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georgeWe’re lucky because we have a park down the street with a basketball court. So we’ll go play a round of H – O – R – S – E. And you know, if I could spell “Horse”, I’m pretty sure Mary-Lynn has beaten me!

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There are a lot of games you can play, from the ones we talked about to board games, that allow you to bring out that fun, little competitive nature and bond at the same time.

We played Wii tennis and it was fun. But we also play tennis at a local park from time to time. It’s a great way to have some fun outdoors.

These are all cheap ways to have some fun, compete, and connect. With couples being so busy, so strapped for time, it’s important to connect in some way every day. If you can do it with a game, so much the better!

I just don’t want Mary-Lynn to keep connecting with me in boxing. Even though it’s a Wii game, it still hurts … my pride!

How do you connect?

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A Better Way to Pay Off Your Mortgage Early

home_mortgageOver the years, a number of ways have been touted to pay off a mortgage early. Recently, we’ve seen a number of solicitations for a new way to do it.

The basic idea is to take out a Home Equity Line of Credit (HELOC) with your chosen bank. You use this account like your primary checking account. You will pay all of your bills out of this account and deposit all of your income into it. Any left over money goes to pay off your mortgage.

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The benefit is appealing – you may pay off your 30-year mortgage in as little as 10 years. Of course, if you have any other debt (e.g. credit card debt or car loan), it’s almost certain you should pay that off first.

We’re talking in generalities here; you and your financial planner can determine your best financial move based on your specific situation.

The pluses

We liked that the program we looked at included a great visual that showed you the exact month and year your mortgage would be paid off if you stuck with it. We also liked that you could easily see your money coming in and going out.

Using intuition

The example showed a rate of 6% on the first mortgage and an 8.6% rate on the HELOC. Intuitively, it didn’t make sense to us to borrow at 8.6% to pay down a 6% loan.

So we decided to do some calculations to see if our intuition was right.

New vs. old

We decided to compare this new way of paying down a mortgage to the oldest of the old ways – including an additional amount with each regularly-scheduled payment.

The example we looked at was for a couple who made $5,000 a month and had bills totaling $4,000 each month. They held a $200,000 mortgage, with a 30-year term, and an annual interest cost of 6%.

The main driver – with the old way or the new way – was the $1,000 in discretionary money each month. The new program also accessed the HELOC in the first or second month, but once again that money is being paid back at 8.6% instead of 6%.

Apples to oranges

We found that the new program lived up to its promise – you will pay less in interest over a 30-year period. The problem is that it’s an apples-to-oranges comparison.

Their basic assumption is that you will use ALL of the $1,000 in discretionary money each month to pay down your mortgage if you are on their program. If not, you won’t use ANY of it – that is, you won’t pay down your mortgage OR invest it.

Apples to apples

So we decided to do our own comparison. We used the simple, old, do-it-yourself extra mortgage payments method – we added the $1,000 of discretionary income to our monthly mortgage payment.

The result?

We paid off all of our debt (which consisted of only a first mortgage) eleven months faster than they paid off theirs (which included the first mortgage and the HELOC)!

We found some of the assumptions about the timing of income and expenses questionable. With a more conservative approach, we would actually pay off all of our debt fourteen months faster using our old-fashioned strategy.

As for total interest savings, we would save between $10,989 and $24,210, depending on the timing of income and expenses discussed in the previous paragraph. This takes into account the cost of their software as well as a small annual fee on the HELOC.

Conclusions

In a strictly financial sense, the old-fashioned way is your best bet. However, it’s important to also consider the human side.

That’s where programs like this come into play – some people would be more likely to pay off a mortgage early because they could track their progress so easily.

Of course, you could set up one account yourself. With basic spreadsheet skills, you could set up a chart (or talk a friend into doing it for you) to show the effect of additional mortgage payments.

The bottom line – the old way is the better way if you’re looking to save the most money. But if you’re a little light on financial discipline, programs like this may be helpful.

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Next time, we’ll discuss a resource that great athletes wouldn’t do without … and neither should you. Until then, here’s to your bigg success!

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I Need Money! Should I Borrow from my Retirement Plan?

balancingWe’ve been talking about money decisions in tough times and how it may affect your 401(k). We started by looking at cashing out a 401(k), which is the absolute last resort.

Next, we looked at cutting back on 401(k) contributions. This is a much better option than cashing out, but you should try to contribute up to the limit of your employer’s matching contribution. That’s found money so you’ll be thankful you did.

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Now, we want to look at borrowing from your 401(k). The best advice we can give you on this is … don’t listen to us! Seriously, we can only talk about this in a general sense. So before you make a decision, talk with your professional financial advisor about the specifics of your situation. Then you can do what’s best for you with confidence.

There may be a better solution

Before you borrow from your 401(k), consider whether a home equity line-of-credit might be a better solution. You may already have one you can tap into. If not, consider applying for this type of loan instead of borrowing from your 401(k).

These loans are not as easy to get as they were a couple of years ago. You also won’t get as much of a line as you might have then because house values in many areas.

How much can you borrow?

If you decide a home equity line-of-credit isn’t your best bet, you can tap your 401(k) up to two times each year for money. It’s your money, so there’s you don’t need to be approved for the loan. You can borrow up to half of the vested portion of your portfolio, with a $50,000 limit.

Pay back is purgatory!

A loan from your 401(k) is a relatively inexpensive source of money. However, you’ll be paying the loan back with after-tax dollars (i.e the interest isn’t deductible). Compare that to a home equity line-of-credit, which is deductible in most cases.

In the eyes of the government, you and your 401(k) are two separate “entities”. So even though you think you’re borrowing from yourself, you’re not – you’re borrowing from your 401(k) so you have to pay it back within five years with an exception for first time homeowners who may have a longer payback term.

You can do that with each paycheck or you can do it in installments. You have to make a payment at least once every quarter. For example, if you borrowed $10,000, you would have 20 quarters to pay back the loan so you would have to pay $500 every quarter plus interest.

Of course, while you’re paying back the loan, you’ll have less money to spend every paycheck or every quarter, depending on which way you choose to pay back the loan. If things are tight now, what will they be like with even less free cash flow?

The other thing to consider about paying back your loan is that the dollars that were taken out of your portfolio are only earning whatever interest rate you’re paying. If that rate is less than what you could have earned if you kept it invested in your portfolio, you’re losing money you would have had at retirement.

No pay back is hell!

So it may be tempting to “borrow” the money and then not pay it back. In the government’s eyes, that’s the same as cashing out. So you’ll have to pay income taxes and, if you’re under 59½, you’ll also pay a 10 percent penalty. 

Analyzing the scenarios

The Center for American Progress Action Fund recently analyzed a number of scenarios [pdf]. Let’s look at the two extremes:

IF you take out a loan, pay it back with interest, and continue making your regular contributions, THEN there is almost no effect on your expected portfolio at retirement. In fact, in all the scenarios they considered under these conditions, there is less than a one percent difference in the end portfolio. Not so bad, huh?

But that ignores the fact that we’re borrowing money because we need it now. So we’re likely to cut back on our 401(k), if not stop making contributions altogether. That’s the double whammy.

IF you do that (i.e. the double whammy), THEN you can expect your savings at retirement to be as much as 22 percent less. 

What if …

Before you borrow, ask yourself some questions. For example, what if your company cuts back and you lose your job? Let’s spin it in a positive direction, what if you get a great job offer? You want to consider these scenarios as well before deciding if you want to borrow now.

Bottom line

Look for other ways to cut back on your spending. Even a little bit here and there can make a bigg difference. Consider temporarily cutting back on your contributions, but don’t dip below your employer’s match if you can possibly avoid it. Borrow if you must, but don’t cash out unless there is just no other alternative.

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