As my team is working on this Capital Budgeting project (which looks to be a good investment so far even though I can’t give you any details right now) I also have an assignment related to capital budgeting and risk assessment as an individual homework item. And as I explained briefly on Monday, the primary assessment tool for a good vs. bad investment is measuring the net present value (NPV) of future cash flows for the duration of the project.
Factors that will affect NPV over a, say, 5 year project include:
- number of units of a product sold
- the price of each unit
- the cost of producing each unit
- depreciation method and period
- tax rate
- initial capital outlay (cost of starting the project, e.g. building and machinery)
- cost of capital
Most of those are pretty clear-cut, if you understand the term, right? If you sell fewer units, you’ll have less total cash flows. Sell more units, get more cash. Price, cost, tax rate: all of those work like one would expect to change the long-term cash flow. And of course if you can save money up front on the initial outlay you save even dollars on Net Present Value, since the initial outlay is always in present dollars.
Cost of capital is one that was new to me. And there’s a reason for that. It has to do with debt.
Samaritan Ministries has, for its entire existence, operated debt-free. So we’ve never done a cost of capital consideration for a project. We don’t borrow money for buildings and equipment, so there’s no interest cost to take into account. NPV, if I didn’t say so before, is a way of taking into account interest cost and opportunity cost when making the initial investment by discounting future cash flows by what’s called the “hurdle rate.” The hurdle rate refers to the “cost of capital” or the discount rate considering the average interest rate a firm pays on its debts.
As you’d imagine, a small (1%) difference in the hurdle rate makes a big difference in the value of a project. In one of the homework problems I’m working on, the range from a 5% hurdle rate (using cash from money market accounts paying out at 2-3% and losing that interest revenue) vs. a 15% hurdle rate (borrowing the money at 12% with a cushion is significant. At 5% the NPV of a four year cash flow is $36,000. At 15% it’s a negative $26,000. That’s going from a positive cash flow to a negative with a $62,000 swing. At 5% investing in the project is a no-brainer. At 15% it’s a really bad idea.
I’ve always thought being debt-free was a good idea, even for a business. And while my finance class feels like, to a great extent, a course in “here’s how to manage debt,” it’s also been a chance to see why operating without financing is a downright good idea.
When I did one of the previous finance projects, I was struck with the amount of debt that the firm I studied had. And it seemed to be a huge problem, and I wasn’t sure how they’d be able to work their way out of it. Therefore I would never have invested in that firm (and am watching them to see what happens in the future!). I’ve invested my life into Samaritan Ministries. Our members have invested a great deal of trust in our ability to operate this organization. I’m thankful that we have a conviction about managing our funds well by not entering into debt, and am very optimistic about our future because of it.
When you have a choice, don’t borrow money. It’s a bad idea. It makes your future decisions more and more bound by your present ones, and it changes future decisions because of your current actions. You want to be in a place where the borderline project in your life is profitable, not where it’s impossible to make work because of the cost of capital. It puts you in the pilot’s chair instead of the tail section of the plane.