Net Present Value

Project B, however, sets your pulse racing a bit more. It’s a less-fashionable low-slung wagon/brake/estate (depending on where in the world you imagine this fictional Board Meeting happening). It too has a hybrid powertrain, albeit with a smaller battery than its internal rival. It’s a far more ingenious engineering solution – that nervous guy from Engineering who pitched the technical slides really did hit the nail on the head by harking on about ‘efficiency’ – if he said the word once, he said it 10 times in his two minute pitch.

The interior is admittedly a bit less funky than the SUV’s, but Design’s deepfake movie of the car driving through downtown Paris looked really cool. The numbers on this one look good, too – the market research shows clear signs that consumers in some countries are at long last starting to tire of SUVs, and that the rationality and good looks of a hyper-efficient modern wagon might just win back some sales from the latest wave of Chinese competitors. And of course the team finished their presentation by appealing to what they know is your weak point – teasing a short clip of a development mule with a breathed-upon powertrain, flared arches and a big boot that they say could be the 21^st century version of the Audi RS2.

Both are great proposals. Both could work very well for your company. But of course you only have the development war-chest to finance one of them. The orgy of PowerPoint finally fizzles out, the CPO thanks both teams, all bright-eyed and flushed with anticipation, and all eyes turn to you. Your call, Boss.

So, folks, how do you think you decide? Do you go around the table and do it democratically, asking each of your trusted lieutenants to give their opinion? Do you trust in your gut instinct, on those years of developing that mythical ‘car guy’ instinct that some CEOs love to claim on their LinkedIn bios? Or do you play it safe, trust the Golden Rule that Design sells cars, and simply go for the better-looking of the two proposals?

None of the above. Sad to say, dear readers, but in this situation any CEO worth their salt will make the decision based largely on a financial tool that you may never have heard of – Net Present Value, or NPV. Believe it or not, these three little letters drive almost every decision that car makers take – whether it be building a new production plant, launching new cars, or replacing the printers in some far-flung regional office. It sounds dry as dust, but bear with me – it’s the calculation that explains why your car has that glitchy software that drives you crazy, or that beautiful steering feel that makes you glad you bought it every time you tip it into your favourite roundabout.

Now, at this point I invite all of you who have had proper financial training to exit stage left, before this gets excruciatingly painful. Because I am an engineer, not an accountant, and I am about to massacre some financial tools here by grossly oversimplifying them. Get out while you have a chance.

Right, for those of you who are left, what is NPV? Well, it’s a financial tool that seeks to compare the present value of a set of future cash in-flows (incomes) to a set of cash out-flows (spends or investments). What exactly do we mean by present value? Well, it’s the simple principle that cash now really is worth what it’s worth, while theoretical ‘future money’ is actually worth less than its face value might suggest.

You know I love a formula, and it’s been far too long. So here you go – the mathematical formula for Net Present Value. You did not ask for it, but you are getting it anyway:

Where:

– t is a period of time – it could be a week or a month, but in the car world, is usually in years

– n is the full period over which the NPV will be calculated – often, the lifetime of a car, which might be as short as six or as long as 10 years

– Net cash in, period t is the sum of cash in, less cash out, in a given period ‘t’

– WACC is known as the ‘Weighted Average Cost of Capital’ – of which more later

Now it looks a bit off-putting, I know, but this formula is basically saying in fancy mathematical terms what every decent small businessperson already knows – financially, a bird (or quid) in the hand is worth more than a future bird/quid that may or may not pop out of some hypothetical bush.

Let’s dig a bit deeper to try to get a feel for what the equation is saying. Car companies look at spending money on new projects as a sort of financial competition between two options. Option one is – we do the car. We spend the billion-odd euros/dollars/pounds, take the four or five years required, accept the additional grey hairs and marital stress, and endure the horrendous grind required to design and build the bloody thing. Option two is – we don’t. We instead take the billion and ask a friendly financial institution to invest it on our behalf. In other words, we decide to act more like a rich investor and not like a car maker at all.

Now, this principle is defined by the term in the equation above called WACC or Weighted Average Cost of Capital. This is basically the interest rate that a car company might get if it called up a financial institution and said ‘Hey folks, it’s MegaCarCorp here. We have a billion dollars going spare, and we just can’t be arsed making another car. What interest rate might you guys give us if we just sent it over to you?’ Calculating WACCs is a financial art/science unto itself and I’m not even going to try to explain it, but depending on the state of the economy and the health of the car company in question, it might range from 8 per cent to 14 per cent for a large car maker. Yes, I know that’s a much better rate than you and I get down at the local credit union, but hey, you and I don’t have a billion of anything to invest, do we?

Right, let’s do a practical example of how you might use this tool in anger. Let’s come down from the heady heights of the CEO and imagine that you are a mere middle-management hack like I used to be – the Chief Engineer in charge of executing one vehicle project. One day, your chassis engineering lads come to you, all bushy-tailed and excited. They have come up with a new way of casting the steering knuckle on your new project, and the good news is that it saves 0.15 cents compared to the current design – which is a straight carryover part from the car you’re replacing. The only catch is that it will cost $150,000 to tool up this new knuckle. To keep this example easier, let’s assume the two parts weigh exactly the same and there is no performance or other advantage to the new knuckle – it’s simply cheaper, but does exactly the same job.

For the sake of our example, the car you are responsible for will have an eight year lifespan and your company will sell an average of 140,000 vehicles per year during its life.

So what do you do?

It’s easy, right? 15 cents saving, 140,000 cars a year, over eight years, that’s a saving of $168,000, for an investment of only $150,000: $18,000 net cost savings. Clap the chassis engineers heartily on the back, next decision.

Wrong. If you had run an NPV calculation, with a WACC of a middling 10 per cent, the Net Present Value of this investment decision (because that’s exactly what it is) is actually -$24,330* dollars, which is a loss, not a gain. In accountant’s language, the decision to tool the new knuckle would destroy financial value, not create it. The equation is telling you that it’s better to keep the money back and invest it – or more likely, keep the money back and give it to another team who presents you with a proposal with a better (i.e. solidly positive) Net Present Value.

Now think about the implications of this for a moment. If you had green-lighted the new knuckle, you are making a financial ‘error’ of about 16 per cent. In a business where profits even of successful car companies are measured in meagre single digits, make just a few of those errors and your career as a Chief Engineer will be nasty, brutish – and short.

How does this make sense? The back-of-the-envelope calculation that there is a gross saving of $18,000 is not exactly wrong. But what the NPV equation is emphasising is that the $150,000 required to tool the knuckle needs to be paid out now – probably a year or two before the car is launched. It’s real cash out that you have to pay out to the supplier or tool-maker now, not later. Whereas the cash inflows from the 15 cents that you save on each knuckle will come in dribs and drabs much later, some of them eight years down the line. That future projected cash in is worth less to you now than the very real $150,000 hit your bank balance will take tomorrow. That’s the gist – and the power – of the NPV calculation: it makes the time-value of money very real indeed.

Now, just in case an accountant or two have hung in there and are now still reading through gritted teeth (if that’s possible), there are of course many other financial tools that car companies – like any large company – will use. There are many other methods of calculating ROIs (Return on Investment), Profitability Indices, breakeven calendar projections – a whole raft of dry financial tools with their drier three-letter acronyms. NPV is not the be-all and end-all. But it – or a calculation very like it – is still the bedrock of any go/no go investment decision.

So let’s go back to our brave CEO, faced with the tough decision between the sensible SUV and the cool new wagon. Sorry to disappoint you, or shatter any romantic images of brilliant captains of industry making tough calls on their amazing business instincts alone. A real CEO will turn to that unsmiling CFO and ask to see the NPV numbers for both projects. They will interrogate them, question them and challenge them very carefully indeed. But they will then make the call on the hard maths. Very simply, the CEO will choose the project with the higher NPV.

It’s usually as cold, as calculating and as downright boring as that.

One final note. In very, very rare cases the maths don’t give a clear answer – the margins of estimation error of volumes or pricing might be greater than the precision of the NPV results. I guess this is where the very best CEOs stand out from the also-rans. Because the greatest of them really do have a true feeling for what stands behind the numbers – they can imagine the vehicles they are describing, and are still close enough to their customers to feel whether those vehicles will appeal to them or not.

Unfortunately, there is no equation for that.

*In the highly unlikely event that you are inspired by this article to play around with the NPV principle, but are somewhat put off by the horrible-looking equation, don’t worry. Those clever lads and lassies at Microsoft have built a handy formula into Excel to do the heavy lifting for you: of course they have. It’s called ‘NPV()’, unimaginatively, and let me tell you, it’s bloody handy. I used it to run the numbers on the case example above, because I’m far too sensible to go to the trouble of hand-calculating an NPV.