A dollar in year five is not a dollar
Every investment decision reduces to one question: is the money you spend today worth less than the money it brings back later? Answering it honestly means discounting future cash back to what it is worth now, because a dollar you receive in five years is worth less than one in your hand, both because you could have invested the money elsewhere and because the future is uncertain.
Payback period, which is what most small businesses actually use, ignores this entirely. It counts a dollar in year five as identical to a dollar today and stops counting the moment the investment is recovered, so it is blind both to the time value of money and to everything the project earns after payback. The systematic result is a bias toward short-lived projects over better long-lived ones.
Net present value fixes both problems. It discounts every future cash flow at your required rate of return, sums them, and subtracts what you pay now. Anything above zero earns more than your required return and creates value. It is the metric lenders, investors and boards expect, and presenting a capital request with it makes the request substantially more credible.
Choosing a discount rate is choosing the answer
The discount rate is the single most influential input and the one most often picked carelessly. Theoretically it is your weighted average cost of capital, blending what debt and equity each cost you. In practice most owner-operated businesses use a hurdle rate reflecting the return available on the next-best use of the money, plus a margin for the risk of this particular project.
A stable cost-saving investment in equipment you understand might be assessed at eight to twelve per cent. A speculative new product line might justify twenty-five. The rate encodes risk, so using one rate across projects of wildly different risk is itself an error.
Rather than agonising over a single figure, run the calculation at several. The rate at which net present value crosses from positive to negative tells you how much room for error the project has. A project that stays positive from eight per cent to twenty is robust; one that turns negative at eleven is a bet on your discount rate being right.
When NPV and IRR disagree, follow NPV
Internal rate of return is the discount rate at which net present value equals exactly zero, and it is popular because a percentage is easy to communicate. It usually agrees with net present value on whether to proceed. It can disagree on which of two projects to choose, and when it does, net present value is correct.
The reason is scale. A percentage is blind to size, so a small project with a spectacular return can beat a much larger project that creates several times more actual value. If you can do both, do both. If capital is constrained, rank by the profitability index, which measures value created per dollar of scarce capital.
Internal rate of return also breaks down entirely when cash flows change sign more than once, which happens with any project needing significant mid-life reinvestment or carrying a large decommissioning cost. Mathematically there can then be several rates where net present value is zero, or none at all. A tool that returns one of them without saying so is quietly misleading you.
The inputs people get wrong
Understating the initial investment is the most common way a business case is made to look better than it is. Include installation, commissioning, training, the productivity lost during changeover, and any working capital the project ties up. The purchase price is rarely more than three quarters of what the project actually costs to start.
Exclude depreciation from the cash flows. It is an accounting allocation, not money leaving the business, and including it double-counts the initial investment you have already subtracted. Do include the tax effect of depreciation if it changes what you actually pay, because that is a genuine cash movement.
Be conservative on project life. Assuming equipment produces cash for ten years when your organisation replaces that class of asset at six is a straightforward overstatement, and because the later years are the ones being discounted hardest, extending the life is a cheap way to make a marginal project look acceptable. Finally, be consistent about inflation: either use real cash flows with a real discount rate or nominal with nominal, never a mixture.
Questions people ask
- What discount rate should a small business use?
- Start with what the money could earn in its next-best use, then add a margin for the project's risk. Many small businesses land between ten and fifteen per cent for routine investments. If you carry debt, your borrowing rate is a sensible floor, since the project must at least beat paying that debt down.
- Is a positive NPV always a reason to proceed?
- It means the project beats your required return, which is the financial test. It does not account for management capacity, strategic fit, or whether a better project is competing for the same money. Use it to disqualify projects that fail and to rank those that pass, not as the sole decision.
- Why is discounted payback longer than simple payback?
- Because discounting reduces the value of each future cash flow, so the discounted total takes longer to reach the initial investment. Simple payback treats a dollar in year five as worth the same as one today, which is never true and always flattering.
- Should I include financing costs in the cash flows?
- No, if the discount rate already reflects your cost of capital, because doing both counts financing twice. Model the project's operating cash flows and let the discount rate carry the cost of the money. Mixing the two is one of the more common errors in amateur business cases.
Sources
- US Small Business Administration. Guidance on capital investment planning and business cases
- business.gov.au. Australian guidance on financing and evaluating business investment
- CFA Institute. Reference material on discounted cash flow and valuation