NPV - ROI : can someone help me in understanding the difference in usage?

Question

Hi everyone!

I'm preparing for case interviews but I do not have any background in business and I am not sure I fully understood when to use and how to compute NPV and ROI. I have read tons of documents on google, but most of the explanations I've found would overcomplicate everything.

Could anyone help me understand the objective, formula, and when it's appropriate to use NPV (and is it safe to use perpetuity?) and ROI?

Also, how do I add the risk calculations on both?

Lastly, in a case where I am required to evaluate an investment, what is exactly the complete set of tools I have?

I am aware of NPV, ROI, Breakeven, Expected value, Payback period.. anything else that I am missing out?

Thanks everyone will be willing to help! :)

Answer 1

OK, an answer on this could fill a book, but I'll do my best.

NPV means, as you surely know, the Net Present Value of a series of Cash Flows (from an investment for example).

That means that all cash flows resulting from that investment are discounted to the present day. Why is this done? Because a dollar today is worth more than a dollar tomorrow.

This is enough to answer two of your questions: Is it safe to use a perpetuity? Yes, if you expect your investment to generate cash flows ad eternam. So, if you calculate the NPV of an asset with a certain lifetime (say a bond with a duration of 10 years, or a 5-year lease on a plot of farmland) then obviously you MUST NOT use a perpetuity.

How is risk factored in? Risk is factored into the discount factor. You discount cashflows with the WACC (weighted average cost of capital). Your WACC will be low for low risk investments (typical examples are infrastructure investments like energy networks, roads) and very high for high-risk endeavors like startups or biotech. How risk is factored in mathematically would far exceed the scope of this posed, but it's based on the CAPM (capital asset pricing model).

If the NPV is positive then this tells you that all future positive cash flows from an asset exceed all future negative cash flows from the investment. You discounted future cash-flows in a risk-adequate manner, so your investment is earning you a positive AND risk-adequate Return on your Investment.

The ROI measures the return on the capital that was invested in an asset. While NPV is an absolute number (NPV of 1 mln USD), the ROI is a percentage. So both numbers tell different stories: If the NPV of an investment of 1 billion is 1 million then it is positive, but barely so. An NPV of 1 million on an investment of 1 million is obviously much better. The ROI makes investments of different magnitudes comparable.

Also, the ROI does not factor in risk at that point. So as a standalone indicator, it does not tell you if an investment has a risk-adequate return. Only if the ROI exceeds your risk-adequate rate of return (so-called hurdle rate), THEN you can say whether the investment is worthwhile.

You can use these figures in a number of different ways to tell stories. You can use them to clarify or to obfuscate, depending on what your goal is. Use NPVs to judge the viability of an investment (NPV > 0 = good) use ROI to compare investments, especially of different magnitudes.

Answer 2

Hello!

Precisely for the high amount of questions (1) asked by my coachees and students and (2) present in this Q&A, I created the “Economic and Financial concepts for MBB interviews”, recently published in PrepLounge’s shop (https://www.preplounge.com/en/shop/prep-guide/economic_and_financial_concepts_for_mbb_interviews).

After +5 years of candidate coaching and university teaching, and after having seen hundreds of cases, I realized that the economic-related knowledge needed to master case interviews is not much, and not complex. However, you need to know where to focus! Hence, I created the guide that I wish I could have had, summarizing the most important economic and financial concepts needed to solve consulting cases, combining key concepts theorical reviews and a hands-on methodology with examples and ad-hoc practice cases.

It focuses on 4 core topics, divided in chapters (each of them ranked in scale of importance, to help you maximize your time in short preparations):

Economic concepts: Profitability equation, Break even, Valuation methods (economic, market and asset), Payback period, NPV and IRR, + 3 practice cases to put it all together in a practical way.
Financial concepts: Balance sheet, Income statement/P&L and Performance ratios (based on sales and based on investment), +1 practice case
Market structure & pricing: Market types, Perfect competition markets (demand and supply), Willingness to pay, Pricing approaches, Market segmentation and Price elasticity of demand, +1 practice case
Marketing and Customer Acquisition: Sales funnel, Key marketing metrics (CAC and CLV) and Churn, +1 practice case

Feel free to PM me for disccount codes for the guide, and I hope it helps you rock your interviews!

Answer 3

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