Determining if a project is worth the money

In a hypothetical scenario, let's say I have the opportunity to take or reject a project, that will cost my company $200,000 this year, and is predicted to get my company the following yearly profits:

This year (2010): $0
2011: $20,000
2012: $50,000
2013: $100,000
2014: $80,000
2015: $30,000
2016: $0

Should I take the project?  On the surface, the project seems to bring in $80,000 profit for the company.  But I should take into account the fact that most of the profits come in years 2013 and 2014.  To see why, imagine that the bank on the corner is offering an incentive to start an account.  Just bring in $1000 and you get $100 cash on the spot.  Would you take that deal?  Now imagine that bringing in $1000 now will get you $100 a year from now.  That doesn't look so good.  Would you take the deal if you had to wait 20 years for the $100?  Probably not.  So how should I go about determining whether the delay is worth it?

It's easiest if I start by figuring out what rate of return I would like from this investment.  (You'll see why in a moment.)  If I work for a publicly traded company, I could use the Weighted Average Cost of Capital (WACC) as a starting point.  The WACC basically tries to answer the question: if my company wanted to raise money for a project today, what interest rate would I expect to pay?  I won't go into the details about how to calculate it, but it tries to predict what people would pay for new stocks and bonds issued by the company.  (While I recommend having someone calculate the value for your company if you were to use it for something important, http://www.wikiwealth.com/ seems to have numbers that are close.)

Now, I said that the WACC should be a starting point.  The reason is that it doesn't take into account any specifics of the project.  If this particular project involves a lot of risk (maybe the sales estimates are uncertain or the estimates are based on the economy continuing to grow) then I might want to adjust the rate higher.  (Riskier projects, stocks, bonds, and most other investments require a greater return if more risk is involved.)   Finally, keep in mind that since the WACC is the rate a company would pay investors for capital, it is essentially the break-even point.  Accepting a project that has returns that match the WACC would be like taking a bank loan at 6% to buy an investment that returns 6%.  In the end that investment has no net gain.

I think that my project isn't particularly risky so I'll just use my company's WACC.  For this example, I'll use both the WACC for Microsoft (9%) and CitiGroup (14%), as determined by www.wikiwealth.com.  I could then find the present value of my profits using Excel.  The present value is essentially a way of telling us the value of a series of cash flows for a given interest rate.  For example, if I wanted to determine how much the project is worth for Microsoft, I would enter:

=NPV(0.09, 20000, 50000, 100000, 80000, 30000)

Where the first term is the interest rate, and all the subsequent terms are the expected profits from each future year.  When I enter this, Excel returns a present value of $213,822.93.  Since this is more than the $200,000 investment for the project, I should accept the project.  What about CitiGroup?  Here is my present value calculation in Excel:

=NPV(0.14, 20000, 50000, 100000, 80000, 30000)

Which returns $186,461.87.  It looks like I would not take the project if I worked for CitiGroup.

I hope that gives you a little bit of insight into some of the finances behind decision making.  As you can see, the process is somewhat subjective (such as determining the interest rate and estimating the profits), but it does give you a relatively easy way of comparing the value of two different projects.