One up on the breakeven point: the IRR

Every local CEO I speak to knows the concept of the breakeven point. It’s a fairly well known and widely used calculation, simply being the point where a business is earning enough to cover its initial costs. That point can be measured in product or currency unit terms and usually incorporates a time when it can be reached.

Given the booming nature of the Beijing market right now, some of these breakeven points are being reached in as little as two to three months. This is obviously good news for many entrepreneurs who can reach profitability in such a short time.

Where it gets a little tricky is when the breakeven point extends out to, say, one year and beyond. When additional time is involved in an investment for small- and medium-sized firms, it becomes more important to factor in the time value of money in the investment process. Why? It has to do with compounding. The longer your funds are tied up in the investment, the greater the opportunity costs for those funds as they would have had more time to compound had the investment been made elsewhere. Ultimately, you will want a greater return from the investment because of the additional time requirement.

This opportunity cost should be a critically important concept for CEOs but, unfortunately, is being missed by many in the local market. Another way of evaluating an investment is by using a “hurdle rate” rather than the more familiar breakeven point. This hurdle rate is the rate of return that the investment needs to reach and even surpass for it to be attractive to the investor. Let’s look at a simple example.

Mr. Liu wants to invest 100,000 yuan in an investment for four years. The investment is expected to pay annual dividends of 25,100 yuan, 24,400 yuan, 12,600 yuan, and 16,200 yuan at the end of each year. At the end of the four years, he also expects to get his 100,000 yuan back. Should Mr. Liu make the investment if he has a minimum investment return requirement, that is, his hurdle rate, of 20 percent?

To answer this question, we apply the Internal Rate of Return (IRR) formula to see if the investment reaches Mr. Liu’s 20 percent hurdle rate.

 

 

  Through a multiple iteration process, IRR is calculated and is equal to 20.5 percent, just high enough for Mr. Liu’s consideration.

During the current stage of China’s economic development, many local entrepreneurs are known to chase quick profits. This has resulted in serious, sometimes dire, consequences for consumers who must suffer a poor product or service quality. Looking ahead, as the economy becomes more mature, local entrepreneurs will likely focus more on building their businesses over the long run rather than chasing the quick buck. As this occurs, I think it’s reasonable to expect to see greater use of the rather sophisticated IRR tool, in addition to the more common place breakeven point.

Writing on finance and economics for the last 18 years, David Seto, CFA splits his time between Hong Kong and Beijing where he reads Chinese classics and tries to revive his defunct band, Scarbelly. Any comments on his columns can be sent to dseto@btmbeijing.com.