Use these simple formulas to help you assess which strategies will truly pay off.
“The Time Value of Money” is a classic concept in financial management. It states that a sum of money is worth more today than the same sum of money at a future date.
In other words, $100 in your pocket today will be worth more than that same $100 in 20 years. This holds true because of its earnings potential, and growth rate, if invested properly between now and that future date.
We see examples of this in the automotive industry all the time. A car purchased for $5,000 in 1935 is equivalent to $40,255.30 today. That same $5,000 today would barely buy you a new set of tires and rims.
Decision makers leverage this concept all the time. The idea of analyzing costs and benefits over time is paramount to an organization’s success. We see examples in dealerships when deciding to purchase new equipment, launch a new product or buy a competing dealership.
The “Discounted Cash Flow Techniques” discussed below provide a practical understanding of creating value within your dealership. They give you a clear and objective reasoning to accept certain projects or to pass on them.
Let’s look at some these techniques and how they can be applied in the automotive space:
The Net Present Value (NPV)
By definition, NPV is calculated by taking the present value of cash inflows and deducting the present value of cash outflows. The beauty of this technique is that it eliminates the time dimension for a decision. Essentially, everything will be stated in today’s dollars.
Here’s an example. Very often dealers are faced with a decision that looks something like this: Should I invest $100,000 in a new piece of equipment? Is it worth it? How can I use analysis to come up with the right decision? How can I present a conclusive decision to our stakeholders that proves the investment is correct?
Here is how it works:
Let’s assume that buying a new piece of equipment will deliver an additional $20,000 of profit every year for the next 10 years and that the market rate of return for a similar project is 6 per cent. This would yield a present value of $147,201—that is, earning the additional $20,000 over the next 10 years is the same as having $147,201 in your pocket today. We would next compare this $147,201 present value of cash inflows to the original $100,000 investment. If the inflows are greater than the outflows, accept the investment opportunity. If not, pass on it.
That’s it! Simple and objective. It provides solid support for making this decision and removes all gut feel out of the equation. Business leaders hate gut feel decisions. Their role in an organization is to create value. And they must be able to quantify the value they generated to truly show their worth. The NPV technique provides just that.
Here is the rule of thumb: Embrace positive NPV activities and run away from negative ones. The higher the NPV, the better.
The idea of analyzing costs and benefits over time is paramount to an organization’s success. We see examples in dealerships when deciding to purchase new equipment, launch a new product or buy a competing dealership.
The Benefit-Cost Ratio (BCR)
To calculate the BCR, take the present value of cash inflows divided by the present value of cash outflows. This calculation is sometimes referred to as the “Profitability Index.” This ratio provides users with another popular way to determine the merit of a project and is just as simple and objective as the NPV calculations discussed previously.
Continuing with our previous example, the BCR, or profitability index, for this project, would equal 1.47 ($147,201/$100,000). Investments are attractive if their BCR exceeds 1.0 and are unattractive if they are less than 1.0. If the BCR is greater than 1, it means that the investment will deliver a positive NPV. That’s always a good thing.
A profitability index of 1.47 tells you that for every dollar invested, that project will deliver a $1.47 return. Again, if the goal is to find objective ways to calculate and communicate the value that can be created by investing in a project, this calculation will do just that.
Going forward, make decisions using discounted cash flow techniques such as net present value and the benefit-cost ratio. Make decisions based on today’s dollars, not tomorrow’s.
This is the correct yardstick to determining which activities will create value in your organization. Using these methods will make you a better operator, better communicator and, arguably, a better value creator. It will allow you to make better decisions and win against your competitors.
Happy value creating!