To understand the real $ value of a project we must understand a few basic financial concepts that are relatively easy to understand. Once we’ve gone through and understand the financial concepts we can use them to evaluate the value of an example project: The return on my rental property. Lets go through the concepts of Cash Flow, Discount Rate, Discounted cash flow, Net Present Value, Depreciation, Internal Rate of Return. It may seem daunting to understand so many financial terms, but believe me, they’re simple and we will master them before you know it!
Cash Flow is the net amount of cash being transferred into and out of a business and is usually measured over a given period, say a quarter, or a year. In a given year, if you spent $10000 on running a business (salary of employee, purchase of business related items) and you generated $11000 worth of proceeds from the business (sale of goods, rental income, etc) your cash flow for the year is +$1000. Cash flow is the most important metric of a business that tells us how viable a business is. A business that is well past the start-up period and consistently cash flow negative (i.e. it spends more money than it makes) you need to question your investment in such a business. An individual’s or a family’s cash flow is its earnings (salaries, wages etc) less expenses (housing, groceries, manicures…etc). If you’re spending less than you make you’re in a good spot and you are “cash flow positive”.
While there are several definitions of the discount rate, I like to think of it as a rate at which the currency loses its value. The purchasing power of $ goes down with time (mostly due to inflation) and the rate at which the purchasing power goes down in a year is referred to as the discount rate. Lets say it costs me $100 to buy a basket of goods today and to buy the same basket of goods next year it will cost me $105. This means that the value of $ goes down with time simply because it takes more $s to buy the same basket of goods as time passes. This rate at which the value of $ goes down is called the discount rate. In the above example, the $ has been discounted by $5 for the year for the given basket of goods that was worth $100 in the first year. The discount rate, therefore is, 5/100 = 5%. In other words, the value of future $ needs to be discounted by 5 % every year.
Discounted Cash Flow
Because the purchasing power of $ goes down with time, any money that a business makes in the future will have a lower present value. The discount rate helps us in determining the present value of future cash flows from a business. A $100 bill today is more valuable than $100 in a year, which in turn is significantly more valuable than $100 bill 10 years later (because of the loss in purchasing power of the $ with time). And so in evaluating a project we need to “discount” the future expected earnings by the discount rate. The further out in time the earning is, the lower its present value. Let us assume we expect to earn $100 for the next three years. Here’s what the discounted value of those future cash flows will look like.
|Discounted Cash flow||100||100/1.05||100/1.052||100/1.053||100/1.054|
|Discounted Cash Flow||100||95.2||90.7||86.4||82.3|
So, a $100 earned 5 years later is only worth $82.3 in today’s $. In other words the present value of $100 five years out is $82.3 at a discount rate of 5 %.
Net Present Value
Net Present Value (NPV) is the sum of all discounted cash flows over the life of a project. So, to determine net present value of a project we need to (a) convert all future cash flows in today’s $ by discounting the value of money earned in the future, and (b) add all of the discounted cash flows together. In the above example, the NPV of the 5 year project = 100 + 95.2 + 90.7 + 86.4 + 82.3 = $454.6.
So the value of the above project isn’t $100 x 5 = $500, but rather it has been reduced to $ 454.6 because of discounted value of future gains. In general, if your project has a positive net present value you should go ahead and do the project.
Depreciation refers to a reduction in the value of an asset over time, due in particular to wear and tear. Any asset (eg. Machinery, rental property) has a useful life beyond which its considered unusable. For tax and accounting purposes the asset value reduces by the amount it depreciates every year. Say I bought a house worth $275000. Tax laws assume 27.5 years as the useful period of the residential asset and it allows us to depreciate the value of the house over a period of 27.5 years linearly. i.e. The house depreciates every year by $275,000/27.5 = $10,000 per year. So as a business if you spend $275,000 in the house your house (asset) will be worth only $265,000 next year. As a business your asset reduced (depreciated) in value by $10,000 and the federal laws allows you to take that evaporated value of $10,000 as a loss on your balance sheet. So, depreciation shields your tax liability on earnings. Assume that your Adjusted Gross Income (AGI) is $100,000 for the year, and you’re in the 30 % tax bracket. Your tax liability is $30,000. However because you had a loss, do to depreciation of your asset by $10,000, you can deduct the depreciation from your AGI and thus your AGI now becomes $90,000 after taking a $10,000 deduction. Assuming you’re still in the same tax bracket of 30 %, your tax liability now would be 30% of $90,000, which comes to $27000. Because of depreciation, you got to save $3000 in tax liability.
Internal Rate of Return (IRR)
Sometimes also referred to as hurdle rate, the IRR is the discount rate at which the NPV of the project becomes zero. Generally speaking, the higher a project’s IRR the more desirable it is to undertake the project. Also, at a given discount rate the higher the NPV of a project, the more desirable it is to undertake the project.
Let’s walk through the example of IRR calculation of a rental property to understand how to apply all that we just learned. Lets assume you purchase a rental property in an association at $220K. You put 20% down and borrowed the rest at 4% for 30 year (Mortgage payment estimator is the first tab in attached excel sheet). We assume the property appreciates 3% every year in value for the period of 30 years. You were immediately able to rent the property out for a monthly rent of $1500. We will assume that you net 11 month rent while one month’s rent is lost in repair, vacancy, property management etc. You also pay property taxes which I’ve assumed is about 2% of the property value. You also pay an association fee of about $300 per month. In the example I assume that both the monthly rent as well as the condo fee will increase 3% annually. Finally I depreciate the property value of $220K over a period of 27.5 years linearly. So the annual depreciation is $220000/27.5 = $8000. You can deduct this amount on your tax return and assuming your tax bracket is 30%, this depreciation saves you $8000*0.3 = $2400 in taxes annually.
The cash flow for year 1 is negative because of the large downpayment. The project starts generating cash from year 2 and continues to throughout the 30 year period. At the end of the 30th year, lets assume you sell the property, which will then be valued at $518.4K simply by appreciating 3% in value every year. This value is called the terminal value of the project. Let us assume we pay 5% sales commission of $25,922 in the 30th year. Next, its times to discount the cash flow for all of the years 2 through 30 and then sum up the discounted cash flow for all years to get the NPV of the project. It turns out that at 11.6% discount rate the NPV of the project is zero. This simply means that your internal rate of return (IRR) for this project is 11.6%. This number is significantly higher than the cost of capital (i.e. the mortgage rate) and therefore is a profitable project to do. The other way to view the profitability of the project is by setting the discount rate close to the actual rate at which the dollar loses its purchasing power. If we set the discount rate to 3%, the NPV of the project is $256K. So, by doing the project you’ll end up with $256K more than without doing the project in today’s dollars.
You can download a copy of the IRR and Mortgagte calculations to play with the numbers and see for yourself. You should notice how $500K of the terminal value is worth only $200K in today’s dollars. Time value of money is a bit hard to grasp and we easily get deceived by a product such as “Term Life Insurance for $1MM”. It really is less than half its advertised value if the expected payout is 30 years out!