If you have a minimum of five years history of even modest sales increase in a respectable and profitable business at a single location, and are contemplating expansion, your first step in deciding an expansion strategy is to be sure you have consistently maximized the current location for a minimum of one fifth of that period.
If you have evidence of consistent loss of more that 15% business during half that period, which you can attribute to space limitations, and have reasonable confidence that the trend will continue to increase, you could be ready to take a closer look at many other factors that should also be considered before looking for capitol. It is imperative when approaching investors to have a thorough and well prepared business plan including financial performance and projections.
One of the big ones is how much will the expansion cost (the initial outlay) and how much cash (operating cash flows) will be generated. A tool to help evaluate whether the operating cash flows generate a return to justify the initial outlay is called Net Present Value (NPV). NPV is a fundamental element of business finance and it is based on the concept of the time value of money.
Here is an example to clarify:
You are presented with an investment option whereby if you invest $20,000 now you will receive $2,000 in one year’s time and $22,000 in two years time. For investments of this kind you expect to get a 5% return. Should you go ahead with this investment? A quick answer to this question is, yes, the investment is good as you will receive $24,000 (2,000 + 22,000) and only outlay $20,000. However, that answer does not take into account the time value of money.
NPV is a tool that does take into account the time value of money. It does this by putting those three cash flows (the $20,000 outflow and the $2,000 and $22,000 inflows) in “today’s” dollars.
What does that mean “today’s” dollars? It is a given that: $100 is worth more today than in one year’s time. NPV quantifies that by outlining what $100 in one year’s time is worth today. You require a 5% return on your investment so that means that the $100 in one year’s time is worth $95.24 ($100/1.05) in today’s dollars. In other words if you invested $95.24 today at your required return of 5% you would have $100 in one year’s time.
This NPV tool can be used to evaluate the $20,000 investment option produces the following result:
Year Cash Flow In Year Divide by Required Return Cash Flow in today’s dollars
- Now -20,000 -20,000
- 1 2,000 1.05 1,905
- 2 22,000 1.05 * 1.05 19,955
- Total (NPV) 1,860
The rule is:
If the NPV is zero or positive it is a good investment.
Note that we need to divide the Year Two cash flows by “1.05 * 1.05” because the $22,000 is received in two years time so to convert it to today’s dollars we need to allow for the required return over two years.
NPV and its relative the Internal Rate of Return (IRR) are important tools when evaluating investment options including deciding when to expand. However they are just part of the tool kit and need to be complemented by such things as:
- Business Environment Analysis
- Industry Environment Analysis
- Sensitivity of Assumptions Analysis
- Marketing Plan
- Business Action Plan
- Skills Gap analysis
Whether you do the NPV analysis yourself or you employ financial professionals such as TeamBRS™ to do it for you, it is important to understand what the results mean so that you can make the most effective decisions.
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