Investment Decision Rules:
Companies and investors will use these 3 common decision rules to decide if an investment is worth pursuing or not:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Payback Period
Today you will learn what each of the 3 is and how you can apply them to your investment decisions you make.
I’ll be demonstrating these rules in the context of real estate so that fellow investors can see how to use the 3 decision rules in determining whether a property is a good investment.
Companies in all industries use these 3 decision rules though as it helps them to decide how much net income to retain and invest for growth vs pay out to shareholders in the form of a dividend. Enjoy!
The NPV Decision Rule:
Present Value (PV) is the value of a cost or benefit that has been computed in terms of cash today. Similarly, Net Present Value (NPV) considers the present value of benefits vs costs in order to determine if the investment is a gain, break even, or loss.
- NPV = PV of Benefits – PV of Costs
If the NPV is positive, the benefits outweigh the costs and you should take on the investment
If the NPV is negative, the costs are more than the benefits and you should not do the investment
The positive NPV left over after subtracting out costs from benefits is the gain the company receives, which can be in the form of cash, value, etc.
Costs are the cost of capital, meaning what your money could be earning in another investment if you were to decline the current investment opportunity being presented to you.
Let’s consider the following example:
Suppose you are offered the following investment opportunity: In exchange for $5,000 today, you will receive $5,500 in one year. If the interest rate you could receive from another investment elsewhere, such as the bank, is 8% per year, then:
- PV of Benefit = ($5,500 in one year) / ($1.08 in one year / every $1 today)
- PV = $5,092.60
In other words you would need to invest $5,092.60 in the bank at 8% to receive $5,500 in one year, and since this investment only costs you $5,000 to receive $5,500 in one year then it is the better deal and you should accept.
- The NPV = $5,092.60 – $5,000 = $92.60 = positive NPV
- The firm will increase its value an additional $92.60 over the next year from undertaking this investment instead of taking the 8% return investment.
When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.
More Advanced Example:
You can buy an apartment building today for $816,000. You estimate that the cash flow from this investment property will be 280,000 per year, starting at the end of the first year and lasting for four years.
- Year 0 you have a cash outflow of -$816,000
- Year 1 cash flow of $280,000
- Year 2 cash flow of $280,000
- Year 3 cash flow of $280,000
- Year 4 cash flow of $280,000
To know if this is a good deal or not we need to know the cost of capital (return you could get elsewhere). You’ve done analysis of other investments and determine that you could achieve a 10% return on investment each year in another property, therefore 10% will be the cost of capital.
First you have to discount each of the cash flows back to today’s present value. What cash value today invested at 10% will achieve $280,000 in 1 year, 2 years, 3 years, and 4 years?
- $280,000 / 1.10 = $254,545
- $280,000 / 1.10 ^ 2 = $231,404
- $280,000 / 1.10 ^ 3 = $210,368
- $280,000 / 1.10 ^ 4 = $191,243
Now sum up the present value of each year’s cash flow and you’ll get $887,560 as the cost in today’s dollars. Compare the benefits to the costs:
- NPV = $887,560 – $816,000 = 71,560 = positive NPV
You should undertake this investment because after 4 years, you’ll receive a total of $887,560 in benefits for a cost of $816,000 today, placing you $71,560 ahead compared to alternative investments.
The break-even point between the two investment opportunities would be at a cost of capital of 14%.
The Internal Rate of Return
The IRR is based on the concept that if the return on investment opportunity you are considering is greater than the return on other alternatives in the market with equivalent risk and maturity, you should undertake the investment.
The IRR of the previous example above was 14% which meant you should undertake it since the cost of capital was only 10%.
IRR Investment Rule: Take any investment whose IRR exceeds the opportunity cost of capital. Turn down opportunity whose IRR is less than the opportunity cost of capital.
I love using the IRR to evaluate investment properties in my real estate business and excel makes it easy for me as I can simply plug in the different cash flow cells to the IRR formula and excel spits out a return. As I adjust my estimated cash flows from the property or the purchase price cash outflow, the IRR changes.
You have a rental property that will cost $500,000 to purchase but will produce net cash flows of $70,000, $75,000, and $80,000 over the next 3 years. Then you can sell out of the investment at a 8% cap rate which means the value of your rental property will be:
- $80,000 / 0.08 = $1,000,000
Excel will be a line of cells: |-500,000 | $70,000 | $75,000 | $80,000 | $1,000,000 |
You’ll enter =IRR and highlight the horizontal line of 5 cells, then add the end parenthesis to look something like this
- =IRR (A1:A5)
Excel will spit out an IRR of 29%
IRR takes into account the return on investment for each year’s cash flows as well as the return on investment you make from selling the property at a higher value than you bought it at.
The year to year rental cash flow returns would be:
- $70,000 / $500,000 = 14%
- $75,000 / $500,000 = 15%
- $80,000 / $500,000 = 16%
- ($1,000,000 – $500,000) / $500,000 = 100%
Add these together and you get a total 4 year return of 145%.
The Payback Decision Rule:
You can also analyze an investment by how long it will take the annual cash flows to payback your initial principal.
If one investment will pay you $10,000/year and you have to invest $100,000 up front to earn these annual payouts, it will take 10 years to retrieve your $100,000 investment.
You can compare the time to other investments and select the investment that pays you back your money the fastest, or in other words, doubles your investment.
You can also use the rule of 72 which requires you to divide 72 by the expected annual return to calculate how many years it will take to double your money or pay it back.
If you think an investment will yield 7.2% per year, divide 72 by 7.2 and you’ll get 10 years. It will take your investment 10 years to double earning 7.2% interest per year thanks to compounding.
Learn –> How to Invest in Real Estate