Launching a new business project is an investment, but it can be a risky one. Two big questions you have to ask are whether you can afford the initial investment outlay and whether the return will be worth it. Fortunately, there are formulas to help you figure it out.
To calculate the initial investment outlay, take the cost of new equipment for the project plus operating expenses such as supplies. Subtract the value of any old equipment you sell off, then add any capital gains tax or loss you make on the sale. That gives you your outlay.
Suppose you run a toy-manufacturing company. Your manufacturing equipment is too old and slow to keep up with demand so you want to replace it, but wonder if the initial outlay finance decision will pay off. The first step in figuring it out is to calculate the initial investment outlay:
- List the cost of the new equipment you intend to buy: $800,000.
- Add in the cost of any added operating expenses or raw materials. In this case, your expenses include $15,000 for training your staff on the new equipment.
- Estimate the salvage value, the amount you'll realize from selling off the old equipment: $350,000.
- Figure out the book value of the old equipment, the amount it's listed at in your account books: $300,000.
- Subtract book value from salvage value and multiply this by the capital gains tax rate. In this initial outlay example, the subtraction leaves you with $50,000. If your tax rate is 15 percent. your tax is $7,500.
- Add the cost of new equipment and the operating expenses together. Subtract the salvage value, then add the tax bill. In this case, that's $800,000 + $15,000 - $350,000 + $7,500= $472,500.
If that's more than you can afford, you'll have to either find more funding or scale back your plans.
If you can afford the initial outlay, that's great, but don't greenlight the new equipment just yet. Your initial outlay finance planning should also look at whether the return on investment justifies spending the money. There are several options for figuring this:
- Payback: how many years will it take before the added earnings from your new equipment pay off the initial investment outlay?
- Internal return on investment: This approach looks at the compound annual rate of return on your project.
- Net present value: This formula looks at how much your project will bring in, then discounts the value to figure what that money is worth in the present.
Payback is simple and quick to calculate, but most analysts prefer net present value. It takes into account that money won't have the same buying power in the future as the money in your initial outlay does today.
To figure net present value, you calculate the cash flows generated by your new equipment over, say, the next five years. Then you discount that to reflect the net cash flow's value in the present. Then you subtract your initial outlay.
Discounting cash flows is a complicated calculation. You may want to use a spreadsheet or a specialized calculator program than trying to do it by hand.
For example, suppose your initial investment outlay is $472,500 and your discounted future cash flows are $400,000. The net present value is negative $72,500, which means buying the new equipment is a money-losing proposition. If, instead, the cash flow is $800,000, your NPV is $327,500.
It's important your estimates for the initial outlay be as accurate as possible. If the figures are substantially inaccurate, it's going to distort your NPV. Being overly optimistic about future cash flows will do the same.