| Return on
Investment (ROI) and Net Present Value (NPV)
The Return on Investment (ROI)
calculations measures the rate of return on your proposed decision
to make an investment in constructing your company's private
warehouse facility. The return on this investment is defined as the
difference between the annualized cost of building and operating a
private refrigerated warehouse versus the annual cost of using a
public refrigerated warehouse. ROI is used by many companies to
refer to their own measure of project profitability. That rate of
return is then compared with other investment options to determine
which option exhibits a potential for a greater return. For
instance, can you achieve a better use of capital by investing in
other facilities, new products and technology, marketing, or in
research and development?
Accounting or
book value ROI calculations assume straight-line depreciation of all
depreciable assets, and a constant annual difference in costs
between the private and public refrigerated warehouse options. When
these assumptions are valid, the ROI calculation is a
straightforward way to evaluate a decision between private and
public options. It fails, however, to consider the time value of
money. In addition, some assumptions used in applying the ROI method
may not be true, such as cash flow differences from year to year.
For example, the ROI method is not appropriate under the following:
-
When additional
capital expenditures are made after the project has started. Not
including these costs will tend to understate the cost of the
private warehouse option.
-
When the use of
accelerated depreciation varies the income tax impact each year,
and calculations are made on an after-tax basis.
-
When the
investment in building and equipment does not occur all at once.
For example, if the purchase of some equipment may be deferred to
coincide with the subsequent increase in revenues generated by the
new project.
A discounted cash
flow method may be more appropriate when cash flows differ from year
to year because it can accommodate cash flow fluctuations, and
because it considers the time value of money. A variation on the
discounted cash flow method is called the "net present value" (NPV)
method, which assumes some minimum desired rate of return. This
desired rate of return is the rate at which the cash flows are
discounted to present dollars. A capital investment proposal is
considered acceptable if the present value of its future expected
net cash flows equals or exceeds the amount of the initial
investment. More specifically, this kit assists you in identifying
net cash flows related to costs of both a private or public
warehouse option, and then calculates the net present value (NPV) of
each. All other factors being equal, you should choose the option
with the lower present value cost.
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