Should you buy the new machine, the software, the second van? Three simple measures help: how fast the investment pays back, how much it returns in total, and what it is worth once you allow for the cost of money. Each answers a different question, and each can mislead if used alone.
Payback = upfront cost ÷ net yearly benefit
Payback is easy to understand and favours safe, quick wins. Its weakness is that it ignores everything after the payback date. An investment that pays back in two years and then stops is ranked above one that pays back in three years and keeps paying for ten.
ROI = (total net benefit over the life − upfront cost) ÷ upfront cost
ROI captures the whole life of the investment, but treats £1 in five years' time as worth the same as £1 today.
NPV fixes that by discounting each future year's benefit back to today's money, at a rate that reflects what your money costs you: your borrowing rate, or the return you could get elsewhere.
NPV = sum of (yearly benefit ÷ (1 + r)^year) + end value ÷ (1 + r)^life − upfront cost
If NPV is above zero, the investment earns more than your cost of money. If it is below zero, the money would do better elsewhere, even if the investment eventually pays back.
A print firm is considering a £15,000 finishing machine. It expects it to save £5,000 a year in outsourcing, cost £500 a year to maintain, last five years and be worth £1,000 at the end. Its cost of money is 8%.
All three point the same way: worth doing, with a reasonable margin. If the saving turned out 30% lower, at £3,000 net a year, the NPV would fall below zero. That is worth knowing before signing.
Test a pessimistic case. If the investment only makes sense when everything goes right, it is a gamble rather than an investment.
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