Finance & Grow Your New Business. Angie Mohr

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      In this start-up company, you would be investing $50,000 of your own money in order to finance the start-up costs of $18,860 and the cash shortfalls in years one and two ($17,060 and $7,250 respectively). By year three, the company is projected to have a cash surplus, which grows annually up to year five.

      You can see that before you even open the doors, you will have to invest $18,860 into the company. Most of that money goes towards buying the sign-making equipment and inventory. Further investments in equipment will have to be made every year as the company starts increasing sales.

      How can we evaluate whether or not this option would be a sound investment? There are many methods of decision analysis. The method we’ll consider here is to look at discounted cash flows. This method allows us to come up with an annualized return on investment. Remember that you will invest $50,000 into this venture. You could have taken that $50,000 and put it in the stock market or invested it in bonds. Both of those activities would have generated a return. In the same manner, we can look at the return from this start-up business.

      The annualized return on investment is simply the amount of funds left over to put in the owners’ pocket after all of the business expenses are paid. Note that we are talking about all the expenses, which includes remuneration for all work done in the business. In this scenario, you will be paid a management salary of $48,000 in years one and two, $59,000 in years three and four, and $63,000 in year five.

      If, however, your cash flow projections don’t allow for you to be paid for your labor, calculating a return on investment is rather meaningless. It means that, not only are you investing money, you are investing your labor for free (this is known as “sweat equity”). In this scenario, however, you are being paid for your efforts and therefore can look at how much you’re getting for your $50,000 investment.

      The net cash available for distribution to the owners looks like this:

      We also know from the above discussion that a dollar received or spent tomorrow is worth less than a dollar received or spent today. This means that we will want to discount this stream of cash flows back to today, to the present value of the dollar, to make sure we are comparing apples to apples, so to speak. The first thing that we need to do is to find a meaningful interest rate at which to discount the cash flows. After speaking with your banker, you know that you can borrow from the bank at 10 percent, so we will use this rate to do our discounting.

      Let’s follow through the example, using a portion of the present value table reproduced below:

      This table tells us, for example, that if we are going to receive a dollar a year from now, it is only really worth 90.91¢ today. You can see that, as we go farther into the future, the worth of that same dollar becomes less and less. We have to bring all of our cash flows back to a common point: today. Sample 2 has completed the calculations.

       Sample 2: Discounted Cash Flows for a Start-Up Business