How to Determine the Value of a Major Purchase

As with any industry, accountants have their own jargon, but a general understanding about some of it is not beyond comprehension for the ordinary entrepreneur and can be quite useful as well as occasionally crucial to sound decision-making. One such area is summarized by the term “discounted cash flow.” This encompasses vital methods for identifying if a major business purchase makes sense.

Determine When the Benefit Arrives

A large amount of spending for your business could be for new equipment or a new product line or an expanded location. But it might simply entail soft costs for an advertising campaign or revamped website. The aim for any of these investments is increasing revenue. The problem is that you spend the money upfront and then wait for the cash to flow in later. Hence, the reference to “discounted cash flow” takes into consideration this time value of money. It recognizes that cash today is more valuable than the same amount of money in the future.

In fact, the expectation of receiving a certain amount of cash next year is more valuable than receiving that same quantity of cash in 10 years. The longer the length of time you expect before generating higher business revenue, the more you have to discount its value.

Present Value of Future Benefits

Identifying the present value of an amount in the future is the whole point of most discounted cash flow determinations. All the future cash flows are discounted by some specified rate. The selected rate, therefore, depends on the length of time before your large expenditure is expected to deliver results.

In the simplest case, you might use a rate you have to pay for borrowing the money to spend. For example, if you borrow money at a 5% interest rate for one year, you want to spend it on something that will generate revenue over the next year that is at least 5% more than the amount you’re spending. Most discounted cash flow calculations are, of course, more complicated than this. They typically require assistance from an accounting professional.

Calculating present value necessitates estimating the revenue expected from making a major purchase. This normally entails gradual revenue increases, which may continue for an extended period but escalate less over time. A discounted cash flow model to determine net present value applies the discount rate to each of the periods over which revenue rises.

Rate of Return

Not all discounted cash flow calculations are made using net present value. That’s because an expenditure can be quite profitable but still have a slightly negative net present value because it returns less than the discount rate.

To correct for this deficiency, accountants deploy another discounted cash flow technique known as the “internal rate of return.” This method identifies the rate that results in a net present value of zero. All the present values of future revenue will equal the money spent at the beginning. This tool is useful when the expenditure occurs over time along with the future incoming cash flow. The internal rate of return also tells you how much is an acceptable interest rate for borrowing the capital needed for a major purchase.

Limits on Tax Deduction of Business Losses

Starting a business has the obvious aim of generating income, but you might experience losses in some years. Although spending more than your revenue is particularly common in the initial year of operation, it can occur whenever unusual circumstances arise that reduce profitability below zero.

Business profits are reported on the personal income tax returns of proprietors, partners in a partnership and shareholders of S-corporations. These are the most common business structures for tax purposes. Business losses are typically deducted on the income tax returns of owners. A business loss offsets income from other sources, thus reducing your overall taxable income. However, the amount of business loss an owner may deduct is limited by at-risk rules.

This means that you must identify how you paid for a business loss. You are at risk for the amount of personal funds invested in the enterprise as well as debt for which you’re personally liable or have pledged property to secure a loan (other than property already used by the business).

You’re only allowed to deduct the losses of a business to the extent you lost your own money and are therefore at risk of not getting it back from future profits. Moreover, a loss you can deduct reduces your at-risk amount in the business for the subsequent year. Fortunately, a loss denied from not being at risk carries over to succeeding years for deduction when you are personally at risk. Determining your at-risk amount is therefore an annual process to conduct with your tax accountant.