How should a company choose what to invest in?
The most logical means of evaluating an investment would be to perform a basic cost-benefit analysis on each investment relative to the others. This is no small task, as with each investment, there is always an element of risk that is difficult to gauge (i.e. maybe sales will jump by 100%, or maybe they’ll tank). There are also more strategic and less concrete benefits and costs which are difficult to assess the value of (i.e. Public Relations, worker morale, etc.)
But let’s say we knew exactly what the benefits in each year would be (i.e. investment A will pay off $10M in two years, $4M in three years, $100M in four years, etc.).How would you evaluate the business choice?
What an economist or a financial accountant will probably tell you is to use some form of Time Value of Money/Discounted Cash Flow analysis to assess the value of each benefit and compare it to the value of the associated costs. The basic principle here refers to the fact that a dollar today is worth more than a dollar tomorrow (because that dollar today can be put in a bank or some other type of investment vehicle and be worth more than a dollar tomorrow). So, Discounted Cash Flow analysis really is just converting all expected costs and benefits to “today dollars” so that we can actually add them up and compare them.
This analysis explains why a company that can always deliver $100 of profit year after year isn’t necessarily worth an infinite amount of money (because next year’s $100 isn’t worth as much as this year’s, and the following year’s is worth even less, and so on).
One common variation of this analysis used by finance types is the Internal Rate of Return (IRR), which performs the exact same Discounted Cash Flow analysis above but summarizes it up in one value which is effectively the interest rate a bank would have to be willing to pay in order to make the costs and the benefits net out to zero (in today dollars). So, a good investment will have a higher IRR because it takes a much higher interest rate at a bank to make someone not want to invest in that opportunity.
To my surprise, however, I learned in training that there are whole groups of firms who do not use either method in evaluating business/investment prospects, but use the much more crude and less technically valid Cash Payback Period. The Cash Payback Period makes no specific allowances for the Time Value of Money (the idea that the value of a dollar tomorrow is less by a factor related to bank interest rates) and is simply the period of time required for a firm to earn enough profit to pay back the initial investment. This technique thus biases the firm towards investments which provide a quick and high cashflow and away from potentially more profitable investments which are slow to return cash (i.e. more long-term Research & Development).
So, big question, why would anybody use this? One possible reason is that smaller firms (who need to worry about paying the bills) or departments without ultimate budget authority may value early cash flow a great deal more.
Another reason, however, seems to be that Cash Payback Period is much easier to calculate and understand. Never mind that it is less accurate (and in some cases not accurate at all), it’s much easier to explain how “in four years, we recoup all costs” than it is to explain “if we discount future cash streams at an annual rate of 12% then the present discounted value of the investment becomes zero”.
What that means, practically, for anyone in the business of giving advice is this: being correct is not enough. You also have to make sure you communicate in terms that the client can understand.