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How to do Financial Evaluation using NPV and IRR

This May and June, in the #TechTribeCommunity, we’re talking all things finances with the ABC’s of Start-up Financials Masterclass Series. On the 25th of May 2021 Sean Moolman, CEO & Founder of the Moolman Institute, hosted a masterclass on financial evaluations using Net Present Value and Internal Rate of Return.  

Thanks Sean! excellent visualisation with different discount rates. – Cristina Rocha

 

Sean took us through the financial metrics, Net Present Value, and Internal Rate of Return and how to use them as they apply to start-up financials.

Key Concepts from the Masterclass

Time Value of Money:

The time value of money is the Opportunity Cost.

“… the idea that money available at the present time is worth more than the same amount of money in the future due to its potential earning capacity.” Investopedia

Present Value & Future Value:

Present Value: The value of one or more future cash flow(s) given a specified rate of return or cost of capital.

Future Value: The value of a current asset at a future date based on an assumed rate of growth over time.

Risk:

“Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return.” – Investopedia

Discounted Cash Flow (DCF):

Future cash flows are estimated and discounted to give their present values.

Net Present Value (NPV):

The net value of current and future cash inflows and outflows (sum of discounted cash flows)

It is the difference between market value (or income) and cost.

Internal Rate of Return (IRR):

Discount rate that makes the NPV of an investment zero.

Limitations of NPV and IRR:

IRR works well for the typical investment profile:

Cash outflow(s) followed by cash inflow(s)

BUT NOT as well for other cash flow profiles

Tips for using IRR:
  1. Don’t use IRR where the cash flow profile is significantly different to the ‘typical investment profile’.
  2. Don’t use IRR to compare cash flow streams with substantially different profiles.
  3. Don’t over-interpret IRR magnitude and rates where IRR is substantially different to real financing and reinvestment rates.
  4. There is no IRR for entirely positive or negative cash flow streams.
Three Key Issues of NPV and IRR:
  1. NPV has a scale problem:

NPV does not take the size of initial investment into account.

  1. IRR has a timing distortion problem:

IRR is distorted by large early cash flows.

  1. NPV has a horizon problem:

NPV does not take different project durations into account. 

How to Overcome the Limitations of NPV and IRR:
  1. NPV does not take the size of initial investment into account:

Use Excess Present Value Index (EPVI)

  1. IRR is distorted by large early cash flows:

Use Modified IRR (MIRR)

  1. NPV does not take different project durations into account:

Use Equivalent Annual Cash Flow (EACF)

Challenges for Attendees

Attendees were given different challenges throughout the course of the masterclass. The winners of the challenges received free access to the Financial Modeling for Entrepreneurs 101: Master the Key Financial Concepts course offered by the Moolman Institute.

Questions & Answers

How do you convert the IRR to interest rate to get a sense of how expensive a loan is or how attractive an investment is?

No conversion necessary, you can just compare them side to side. There are limitations in terms of IRR, but you can directly compare the two.

Is the IRR like break-even point?

No, the break-even point refers to a time into the future when you have earned back the same amount as your investment. NPV and IRR look at all of the cash flows and would be a better metric to use than the break-even point.

How do you perform NPV analysis on irregular cash flows based on estimated inputs?

If the cash flows are not periodic you can use XNPV, and this is also built into Excel.

What is the practical application of NPV and IRR when making an investment decision?

There are many methods to value your business. There is a middle ground of effort that you need to put in when considering your business model. The gold standard is called the Discounted Cash Flow Method. You produce financials for your business for a series of 5 years and then use NPV to calculate the present value of all those cash flows. The NPV value that you end up with will be the evaluation for your business.
Missed the workshop? Catch up here:
Coming up next is Understand and Analyse Financial Statements hosted by the Moolman Institute on 23 June 2021.

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