Choosing which projects to invest in is among the most important and most consequential decisions a small-business owner will make -- especially when you consider that many small businesses have limited access to capital. Using the net present value, or NPV, method of evaluating investments can help you sort winning projects from losers and help you ration your capital effectively.

NPV Method

In the net present value method of investment appraisal, you first estimate all the positive and negative cash flows associated with the project you are considering. Start with the upfront costs -- a negative cash flow -- and then estimate the cash flows each year into the future. The next step is to determine the "present value" of all future cash flows -- what they're worth in today's dollars, adjusted for inflation, borrowing costs and other associated factors. Once you've determined the present value of all cash flows, simply add them up. The total is the net present value of the investment. If the NPV is positive, the project is a moneymaker. If it's negative, it's not worth doing.

Capital Rationing

Small businesses don't have the kind of access to capital markets that big corporations do, meaning they have a more limited pool of funds from which to draw. You may have dozens of positive-NPV projects available to you, but each of those projects requires an upfront investment. You have a limited amount of money on hand, a limit to what you can borrow and a limit to what you can raise from investors. Choosing the best use of limited resources requires a system for "capital rationing."

NPV Order

When comparing two or more projects, the one with the highest NPV is typically the best choice. So the simplest way to apply the net present value method to capital rationing is to determine the NPV of each project and then list them in order from highest NPV to smallest. Starting from the top of the list, take as many projects as you can afford. For example, imagine you had $100,000 in capital to invest and six potential projects to choose from: 1. NPV: $30,000. Upfront cost: $40,000. 2. NPV: $12,000. Cost: $50,000. 3. NPV: $10,000. Cost: $20,000. 4. NPV: $7,500. Cost: $20,000. 5. NPV: $4,000. Cost: $10,000. 6. NPV: $3,000. Cost: $10,000. Under this method, you would pick project No. 1 and project No. 2. You don't have enough money to do No. 3 as well, but since you had $10,000 left over, you could go down the list and grab project No. 5. Your total NPV is $46,000 from $100,000 in investments.


One problem with using net present value for capital rationing is that it takes into account only the raw amount of the NPV. It doesn't measure how efficiently an investment generates that NPV -- how much payback you get for each buck. For example, in the previous list of projects, the second-ranked project chewed up half of your capital. That's why many businesses tweak NPV for capital rationing with a metric called profitability index, or PI. The PI of a project is simply its NPV divided by its upfront cost. Reordering our six projects by PI, we get: 1. NPV: $30,000. Cost: $40,000. PI: 0.75. 3. NPV: $10,000. Cost: $20,000. PI: 0.50. 5. NPV: $4,000. Cost: $10,000. PI: 0.40. 4. NPV: $7,500. Cost: $20,000. PI: 0.38. 6. NPV: $3,000. Cost: $10,000. PI: 0.30. 2. NPV: $12,000. Cost: $50,000. PI: 0.24. Now you can take the top five projects, generating a total NPV of $54,500.