Measurements of return
Measures of Return
Understanding the different measurements of return on your investment
Welcome back and thank you for joining me in my quest for financial intelligence. It's been a busy month for myself and my family as we are nearing the 9th month of our pregnancy! This baby is expected to arrive any day now. Say a little prayer for us while we adapt to being a family of 4. On Note news, this week were going to be discussing Measurements of Return such as NPV, IRR, and Cash on Cash return. Finding what type of investment you're going to do sometimes seems like the easy part. The hard part is in the evaluation. It's what will make or break a deal for you and if you don't know how to evaluate your investment you can get into some trouble pretty quickly. Let's jump right in and see how some of these measurements are used.
NPV - Net Present Value
NPV comes up often when measuring your return. It is a measurement of Discounted Cash Flows. By using discounted cash flow analysis we can compare cash flows coming at different times in the future by converting future cash value into their values today.
For example, A machine costs $60,000 and it will generate $12000 per year for 5 years. It will be sold at the end of 5 years for $20000. The discount rate ( aka interest rate) is 8%.
Year 0: - $60,000
Year 1: + $12,000
Year 2: + $12,000
Year 3: + $12,000
Year 4: + $12,000
Year 5: + $12,000 + $20,000
Using the formula we see that the value of the values at their discount rate is $61,524. The cost of the machine is $60,000 giving us an NPV (Value to us today) of $1,524.
When looking at NPV we want to follow three basic rules
IRR - Internal Rate of Return
The IRR tells you how efficient (in time) your return is to your investor by determining the % earned on each dollar invested for each period invested. The IRR is the rate of return that makes NPV = 0. As the rate moves up, the NPV rate goes down and visa versa. The easiest way to determine IRR is to use a financial calculator by inputting the cash flows for each year. The advantages to IRR are that it leads to the same decision as NPV for independent projects with conventional cash flows.
Often the most important measurement of return. It determines Cash In vs Cash Out. For each dollar, you put in, how much do you get back.
For Example I invest $1,000. In the same year, I receive $100 back. My Cash on Cash return is 10%.
Now imagine this. A home has a value of $200k. We purchase it for $160k. We put a down payment of 20% making our loan $128k. We put in $32k (downpayment) and decided to offer a 2-year lease option on this home. We ask the potential purchasers for $5k down with a monthly payment of $4800. At the end of two years, we will have made $14,600. Each year making $7,300.
Our cash in this deal is $32,000. Each year we receive $7,300 making our COC return = 22.8%
By now your head is probably spinning. Some of these terms are difficult to understand. What do you consider to be the most important measurements of return when evaluating a deal? Do you utilize all of these measurements of return?
Understanding the different measurements of return on your investment
Welcome back and thank you for joining me in my quest for financial intelligence. It's been a busy month for myself and my family as we are nearing the 9th month of our pregnancy! This baby is expected to arrive any day now. Say a little prayer for us while we adapt to being a family of 4. On Note news, this week were going to be discussing Measurements of Return such as NPV, IRR, and Cash on Cash return. Finding what type of investment you're going to do sometimes seems like the easy part. The hard part is in the evaluation. It's what will make or break a deal for you and if you don't know how to evaluate your investment you can get into some trouble pretty quickly. Let's jump right in and see how some of these measurements are used.
NPV - Net Present Value
NPV comes up often when measuring your return. It is a measurement of Discounted Cash Flows. By using discounted cash flow analysis we can compare cash flows coming at different times in the future by converting future cash value into their values today.
For example, A machine costs $60,000 and it will generate $12000 per year for 5 years. It will be sold at the end of 5 years for $20000. The discount rate ( aka interest rate) is 8%.
Year 0: - $60,000
Year 1: + $12,000
Year 2: + $12,000
Year 3: + $12,000
Year 4: + $12,000
Year 5: + $12,000 + $20,000
Using the formula we see that the value of the values at their discount rate is $61,524. The cost of the machine is $60,000 giving us an NPV (Value to us today) of $1,524.
When looking at NPV we want to follow three basic rules
- NPV > 0 = Acceptable
- NPV = 0 Indifferent
- NPV < 0 = Reject
IRR - Internal Rate of Return
The IRR tells you how efficient (in time) your return is to your investor by determining the % earned on each dollar invested for each period invested. The IRR is the rate of return that makes NPV = 0. As the rate moves up, the NPV rate goes down and visa versa. The easiest way to determine IRR is to use a financial calculator by inputting the cash flows for each year. The advantages to IRR are that it leads to the same decision as NPV for independent projects with conventional cash flows.
- If required rate of return < IRR, NPV > 0, Investment is Acceptable
- If required rate = IRR, NPV = 0, Investment is Indifferent
- If required rate > IRR, NPV < 0, Investment is rejected
Often the most important measurement of return. It determines Cash In vs Cash Out. For each dollar, you put in, how much do you get back.
For Example I invest $1,000. In the same year, I receive $100 back. My Cash on Cash return is 10%.
Now imagine this. A home has a value of $200k. We purchase it for $160k. We put a down payment of 20% making our loan $128k. We put in $32k (downpayment) and decided to offer a 2-year lease option on this home. We ask the potential purchasers for $5k down with a monthly payment of $4800. At the end of two years, we will have made $14,600. Each year making $7,300.
Our cash in this deal is $32,000. Each year we receive $7,300 making our COC return = 22.8%
By now your head is probably spinning. Some of these terms are difficult to understand. What do you consider to be the most important measurements of return when evaluating a deal? Do you utilize all of these measurements of return?
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