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The question must be very simple but I'm still struggling.

Let's suppose that I have an import-export business. Then I have a discounted CF which is formed by subtracting all costs & taxes from the revenue. I do not understand if I have to count initial costs for normal transaction (1 deal/cycle of trading goods) as IC to count NPV for such a project. Is it OK to say that a project where I put $100,000 per each transaction, and get a return around $120,000 does not have -IC given that each time every deal costs me 100,000 dollars?

Unlike an "ordinary" investment project where I have IC, for example, -$100,000 spent on special equipment or whatever, the trade transactions imply that this initial 100 thousand dollars will not disappear but actually will be there after each transaction is completed.

On another hand, we can say that those 100,000 dollars are frozen for a certain period, and then it can be considered a -IC. So, which is the right way to calculate NPV for trade projects where we do not have actual investments except turnover capital we use to trade?

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    It looks like you are considering a 'turnkey' "drop shipment" business, possibly one advertised to you online. BE CAREFUL. If it was actually 'free money' as you might be told, then why would the advertisers not just do it themselves? Why let the public in on the money making opportunity? You appear to be in over your head, because you are using terminology in a way that misaligns with common understanding. ie: you call it "discounted cash flow", but you haven't shown that you are actually "discounting" your cash flows. It is good to ask questions. Be careful you don't invest blindly. Nov 29, 2023 at 22:20
  • @Grade'Eh'Bacon No, fortunately, it's not a 'drop shipping' type of business but rather a traditional reselling: we buy goods from A and sell to B in another country, and in this case we are investing in our own business. And I am trying to calculate the 'final result' of this endeavor, while being not quite financially literate. As I see it now that If I consider the first 100k to be 'investment', it will take many years to recover from this 100k from profits made during this period. However it's not the case for trade, where we just input cash C for period T, and get output C+% for every T.
    – Gigigi
    Nov 30, 2023 at 15:20

2 Answers 2

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I may not fully understand the scenario, but ALL cashflows are included when you are doing an NPV analysis. IF the timing between the purchase and sale is very short, you could possibly just count the net profit as "cashflow" and discount it back to the present.

However, I'm not sure an NPV analysis is the most suitable here. It sounds like your model is to make purchases over time, then sell them for a profit. The NPV of such a model will ALWAYS be positive unless you have very large lags between the purchase and sale.

NPV is more suitable when you make a large upfront purchase that generates cashflows over time, to see if the project is more profitable than, for example, investing it is something else with equivalent risk (and expected return).

Another way to look at it is to look at the first 100k as the "seed capital", then assume the profits from the first sale will finance the second, etc., until you eventually sell the "last" item to recoup you initial investment. The NPV analysis would then discount the net profit of each sale back to the present, and would tell you if the plan is more profitable than investing the 100k in something else (discounting the cashflows at the alternative rate of return).

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  • Thank you for your answer! Yes, it is basically the simplest trade model: we just buy and sell to make profit. And the thing is that if I consider the first 100k (which is an equivalent to the cost of 1 transaction) to be a "seed capital", it will take me 5 years (by actual numbers, not for this particular example) to recapture investments, which means to get the discounted net profit more than that 100k used as turnover capital. And 5 years is a long period. I guess that the original meaning of NPV applying to this sort of business leads to conclusion that such a model is always positive.
    – Gigigi
    Nov 29, 2023 at 21:10
  • NPV of this model may or may not be positive, depending on the rate of return assumed. That is a critical component missing from the analysis, which once included makes the whole thing make sense. Nov 29, 2023 at 21:58
  • @Grade'Eh'Bacon I was thinking if the sales are immediately after the purchases, then you effectively only have inflows (net profits) and thus the NPV will always be positive. It would only be zero/negative if you model it as an initial outflow and then use the inflows to "finance" the next outflow, only recording the net profit as the inflow. But I may be missing something...
    – D Stanley
    Nov 29, 2023 at 22:43
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    @DStanley You could be right; if funds are received same day the cost of money would be 0, and if they are received shortly after, you would just need to calculate for the number of days when the cash is outstanding. Maybe I am incorrect in assuming that inventory is bought first prior to turnover. Never looked into dropshipping. Nov 30, 2023 at 15:00
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First, you haven't indicated that you've considered the actual time value of money, which is a critical component of NPV analysis. Actually, it seems that you have only considered a 'cash payback model', because you're saing that earning 120k off 100k of inventory will pay for itself in 5 years [20k cash returned per year, above the initial inventory costs]. Once you factor in the fact that your initial purchase of inventory happens today, and your sales revenue is received in the future, you will better understand how to consider that inventory cost.

Simplest version:

Assume your product turnover is 1 year, you have 100k of input costs, zero fixed costs, and 120k of revenue, which you will get in 12 months. Your cash profit will be 20k in year 1. BUT - what is the 'discount rate' that you should use to reduce the value of dollars received in 12 months vs dollars spent today? One method is to use the rate you would get on other investments / the rate you would need to pay in interest costs to borrow funds. ie: if you have the ability to earn 4% in interest, you could call your discount rate 4%.

Plug those numbers into a financial calculator, and earning 120k in 12 months after putting in 100k total costs today, would be worth 115,384. You can test the math quickly by saying: 115,384 * 1.04 = 120k, meaning 115k in a bank account earning 4% interest would be worth 120k in a year. Your NPV of this is therefore 115,384 - 100k initial investment = 15k net value.

Now, consider that 4% is not a sufficient rate to compensate you for the risk you are taking. 100k in a government-insured bank account has no risk [government collapse aside], so to engage in a risky venture, you should expect to earn more. Maybe 10% would be appropriate, maybe 20% would be appropriate.

If you assume 20% return would be worth it to compensate you for the risk you are taking, then 100k today would earn you 20k in interest over 12 months, and therefore your NPV in such a scenario would be $0. Counterintuitively, this doesn't mean "not worth it", it means "exactly worth it for the amount of risk I am taking".

Now if you expect to turnover, say, once a quarter, then your 'cash profits' would be 20k x 4, and we can simplistically assume you are able to use the profits from each turnover to pay for the next round of inventory. So, your cashflow pattern would be:

Today: - 100k 3 months from now: +20k 6 months from now: +20k 9 months from now: +20k 12 months from now: +20k

The simplest way to consider the ongoing in/out of the money would be to just take 1 year as a natural starting point. So, your final cashflow in 12 months would be +120k, representing that you will not be rebuying your inventory to sell again.

If you plug those dates into a financial calculator with a required return of 4%, you get a PV of all inflows of 174k [ie: not worth the full 180k in cash, because the money is received over time instead], which is 74k higher than your initial inventory cost, so an NPV of 100k. Using a rate of 20%, you get PV of 153k, which would be NPV of 53k.

An even more simplistic approach you could use to wrap your head around this, would be just to include a line item in your cash flow analysis called 'interest payment', like "100k * 4% interest = 4k in lost value". Remember that 4% would not be compensating you for the risk of the business, just the barest minimum form of lost opportunity cost.

In short, one way or another, you need to consider the opportunity cost of not having your cash tied up in this investment, as well as the risk factor of running a business.

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  • Yes, you are right at the point that I haven't indicated anything about discounting whatsoever but the question was more about which type of calculating the NPV is appropriate for trade business: should I start from 100k as minus IC or just consider this business as one without initial investments. After I checked the way the interest rates apply for bank deposits, it became clear that this calculation of NPV does not require that -IC for this case because this way the bank deposit would be recaptured after like billion years.
    – Gigigi
    Nov 30, 2023 at 15:26
  • @gigigi You need to discount the cashflows according to when they occur. Money earned later is worth less than costs paid today. You need to start from -100k, and show your +120k as coming in the future at a reduced present value [throw in 10% annual discount rate as a starting place, but that may not appropriately capture risk depending on the business]. Nov 30, 2023 at 15:29

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