With unemployment above 10 percent the federal government is considering another stimulus package in an effort to create or save more jobs. The idea of spending more stimulus money gives us pause. We do believe that stimulus money can truly stimulate the economy, but only if the money is spent in a financially intelligent way, that is, allocated to projects that have a positive net present value (NPV).
As small business owners we know that when we allocate our capital to projects with solid net present values we improve and grow our business. Net present value is a capital allocation tool used to compare the value, in real cash, of the future benefits of an investment to the initial costs.
Here’s how you compute net present value:
1. Determine the initial investment involved in the capital project.
2. Project the future benefits of the project in cash flows.
3. Determine the minimum interest return the investment should generate.
4. Discount the future projected cash flow using the minimum rate of return and compare it to the initial investment.
5. If the present value of the future benefits exceed the initial investment, then the project should be funded.
6. If the present value of the future cash flow is lower than the initial investment then the project should be scrapped.
Taking on projects with negative NPV will put a small company out of business. With limited capital one needs to make sure that the cash generated by the business is invested in a way that will improve returns.
Government stimulus money can improve our economy if the money is allocated to projects that generate positive NPV. Capital expended for political purposes rarely, if ever, takes NPV into account.
Several years ago Joe taught a corporate finance MBA class as an adjunct professor at Westminster College, a small liberal arts college in Salt Lake City. In this capacity he was asked to observe and mentor a new professor of finance. This professor happened to be a senior finance executive for the State of Utah.
The topic for the class was capital budgeting tools, including net present value. As an example, the State of Utah finance executive used a major conference center project that was planned for a small community in Southern Utah. As he presented the numbers and explained the NPV concept, it was clear he did not really know how to calculate net present value. After struggling for a bit he asked Joe to step in and teach the concept. After Joe completed the analysis with the class, they found that the project had a negative NPV. In other words, the cost of the project was not justified by its benefits.
Given the results, Joe noted that the State of Utah should not undertake the project. The state executive replied, “Yeah, I know this project had a negative NPV because we had some outside consultants calculate it for us. But we started the project anyway because everyone at the state wanted it and it was approved by the Governor’s Office.” At that point Joe said if he ran his business that way, it would be out of business in short order. Everyone in the class laughed except the state executive.
NPV is an important tool for the private sector. Government employees and lawmakers should also use NPV to determine whether public projects and stimulus packages are justifiable.
Originally published on Harvard Business Review Blog.