How the NPV Formula helped show me the Light, or at least some of the wavelengths

Back in college, I was quite motivated in taking a few management courses along with my engineering degree.  I figured that since becoming a manager in industry is the natural progression for ambitious individuals, that I should learn about it.  Unfortunately, for the most part, those courses were not very useful.  Unlike science and math, where you can prove things to be true from logic and experiment, theories and principles of management are practically unprovable and you can only hope that what you’re told is remotely close to the truth.  Personally, I do believe there is a science (and natural laws) to management, it’s just that, like economics, you can’t really validate if your theorems (management styles) are true, unless you could simulate a controlled experiment with civilizations and organizations of people managed by people using different management styles.  For the most part, the best we can do is make observations and logical deductions to carry us to conclusions that we unfortunately can’t test, except over the lifetime of our civilization and organizations, assuming we’re measuring and accounting for all the important variables along the way, which we probably aren’t.

But there was something that stuck with me from one of those management courses (ironically from a technical elective for my engineering degree rather than from any one of my management minor courses), and that was Net Present Value (NPV).  Probably because it revolved around an equation, which was a godsend to me when learning about management (I was also finishing a minor in mathematics).

The idea of NPV is to calculate the present value of some business or accounting entity.  Some examples could be an asset like a stock, a liability like a loan payment, a project with expected investment and future earnings, or a whole business with expected annual income over many years.  These entities will have predictable (more or less) future positive or negative incomes.  You sum up those incomes over the lifetime of the entity, discounting income in the future by a discounting factor.  The number that you would calculate, would then tell you the present value of that entity.  Calculating the NPV is how you can compare between different entities that you may potentially purchase or invest in.  You will invest in the entity that has the highest NPV.  So effectively, this equation is a mathematical way of making decisions when it comes to investing your resources or cash.

NPV is used much in project management (which is the context I learned about it initially), where you determine the upfront investments of the projects (capital expense, labor, research, marketing, etc.) and then the prospective earnings once you launch your product or service to customers who will buy it.  A company has only so much money/cash/resources at hand, and has to make a choice between what prospective projects look the most promising.

The NPV formula is not perfect and can be easily perverted in its use.  Some examples being: you can overestimate future incomes, underestimate initial investment and costs, choose a very low discount factor, or poorly predict the entity lifetime.  Personally, I currently like to use the NPV formula to calculate expected rate of return (ROI), which I think is a more efficient decision making measurement.  That way you can get around choosing a “risk free” or “similar risk” discount factor, along with potentially missing projects or ideas that are “low hanging fruit”.

I’m not going to go into the specifics here on NPV’s proper use, instead, I just want to get across some of the realizations that the NPV formula gave me.

One realization being that there exists an analytical way that we, actors conscious of future events, can choose what to do with the resources we control in the present.  A way that can dictate decision making.  The more knowledgeable we are of future events, the better we can make decisions in the present.  Of course this is common sense, but now I have a way to analytically describe what is common sense, and quantify it.   This analytical technique is heavily reliant on the accounting of money and capital.

A second realization (stemming from the first) is that the scope of NPV is not limited to just a few managers overseeing a portfolio of projects.  We all manage resources.  Most notable of which is our time, which really means our bodies.  We control what we do with our body, since we own it.  Out of all the paths and choices in front of us (getting a part time job, getting an education, starting a family, reading a blog post, eating food, play video games), how do we manage which choices are the best to do with our bodies?  We can’t just duplicate our body and do all possible actions simultaneously.  We must make a conscious choice.  We must make a compromise between all the things we want to do and choose the action that will be most beneficial.  NPV is the guide that can direct all decision makers, big or small, of how we should manage the resources we control.  We direct our property, just as the manager directs company resources.

A third realization (stemming from the second) is that the NPV formula allows us to realize the importance of opportunity costs.  For example, if you are a manager of $1M in cash, how do you determine what to do with it?  Let’s say you calculate the NPV of a possible project, and over the lifetime of 10 years, assuming no inflation, it has an NPV of $500k.  This means that after 10 years of the project, you can expect to have $1.5M leftover, a gain of $500k.  That’s not bad right?  After all, if we’re a capitalist, making profits is our goal, and we were successful.  Well, if you had instead just put that $1M in the stock market, say a mutual fund with average rate of return of 7.5% and 0.5% expense ratio, after 10 years, you would end up with $2M, a gain of $1M.  Simply placing it in the stock market has a NPV of $1M, which is a relatively easy thing to do.  Managing and overseeing a $1M project is obviously much more work than simply placing the money in some brokerage account and letting the fund managers do all the work for you.  You may have really though the project was a good idea, but the NPV formula is ruthless is determining if your project is worth the limited resources available.

Comparing what you can do with your cash and resources to the stock market is a brutal reminder to managers of companies that you have to come up with ideas and projects that have much more higher expected rates of return than just 7%.  The expected rate of return of the $500k project was just 4%.  Managers and employees need to be coming up with ideas that far exceed 7%, otherwise, why does their company even exist?

I recommend just looking up the NPV formula and I hope you may come to similar realizations.  Calculating internal rate of return via the NPV formula is a very effective decision making method for managers when determining capital budgeting.

We all can be managers though, managers of our bodies and our wealth.  That’s what it means to be sovereign.  Realizing the concept of NPV is one step towards consciousness of that sovereignty.

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