If you want to invest in a property project, you need to know beforehand whether the project will give you fair return on not. If not, you should find other projects instead. One of the mistakes beginners often make is that they are not meticulous enough to check the expected return.
NPV and IRR are the two most common method of financial analysis to estimate the profitability of potential investments.
A Glimpse on NPV and IRR
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
The Internal Rate of Return (IRR) is an indicator used in financial analysis to estimate the profitability of potential investments. IRR is the annual rate of growth an investment is expected to generate. IRR is calculated using the same concept as NPV, except it sets the NPV equal to zero.
These two methods use time value of money concept. It means that the money you have now is worth more than the identical sum in the future. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received.
The easiest way to understand this is with the inflation situation. Because of inflation, the same IDR10,000 could buy you 10 bowls of noodle soup in the 1980s, but only 1 bowl in the 2000s, and may not be able to buy any in the next 10 years. So your money is worth more today than tomorrow.
So, let’s learn to calculate NPV and IRR of a property project with these simple steps.
1. Determine Current and Future Investment
First of all, you should be ready with your business plan on your property project. In the business plan, you should be able to see the investment required for the project, either it is needed just before the plan starts or along the development period.
Investment is cash outflow. So, you put minus sign to indicate that it is an outflow below the year associated with it.
2. Determine Net Cash Inflows
Of course, after the project is done you expect an income stream. It can be in lump sum due to sales of the whole project. It can also be recurring income over the years from rental revenues.
But don’t just put in your revenues. Remember for generating the revenues, you will have to incur costs. Costs are cash inflows. So net cash inflows are revenues net of costs.
Usually the early years of the project, you will only see negative net cash inflows. This is intuitive because the project is being marketed, and marketing only incur immediate costs but not necessarily direct sales. Don’t worry, as long as your plan can explain the reasons for it.
3. Determine Your Expected Return
Expected return of your investment should consider these factors:
- Inflation rate
- Risk free interest rate
- Risks of the project
You should consider inflation rate because if your projects cannot deliver higher return than inflation rate, then you are worse-off due to it. Your decision to invest will make your money diminish rather than enlarging.
Risk-free rate is rate given to risk-free assets such as government bonds and time deposit. It is just logical if your investment generates higher return than risk-free rate. Otherwise, you should just invest in risk-free assets – at least you will have a better sleep every night.
Risks of the project is much more difficult to be determined. The rationale is the higher the risks, the higher the expected return.
How can you determine risks of a project? Check list everything that could happen to the project. Discuss with people who knows the project and try different scenarios. But even then, you cannot really put a number on ideas.
So, go to the capital market. Find stock of companies in similar industry and calculate the return. Increase the resulting number a bit just because you have a new and unproven project. Also increase a number a little bit more if you have a significantly different situation that raises the risks of your project.
Make sure you are comfortable with the number. A risk taker would set a lower number than those of a risk averse investor. Just saying...
4. Calculate Net Present Value
Put all the numbers in tables. Use Microsoft Excel to do it, or you can do it manually.
Consider this project: Investment of the project is needed twice. One is in Year 0 (now) of IDR2.5 trillion, and second is in Year 2 of IDR100 billion. Revenues in Year 1 to Year 5 are: IDR400 billion, IDR600 billion, IDR 1 trillion from Year 3 to 5. Cash Costs for each year is IDR250 billion Your expected return is 25%
This is how you should put all the data in the Excel (look at the gray areas).
Then if you want to use Excel provided formula, just find NPV. Remember to reduce it to your beginning investment.
If you see, the result is negative. It means that your project cannot meet your expectation of delivering a return of 25%. The recommendation is that you do not follow on the project, unless if you can change the plan to deliver better return.
One other mistake to make is that people tend to crunch the numbers but not the business plan. Don’t. If you want the number to change, then try to find holes in the business plan. The number obviously will change and become positive if you raise the revenues. But if nothing changes in the plan, then in reality the second revenues estimate might not be reached.
5. Calculate the Internal Rate of Return
To confirm the NPV result, find out the IRR. You can just put in the formula provided by Excel. You will see the example project results in an IRR of 2%. It is far below your expected return.
Now you understand how to calculate a NPV and IRR of a property. Use it wisely and good luck.
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