financial feasibility 10a

8/8/2019 Financial Feasibility 10a

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Evaluation of Financial feasibility of

CP options


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The Cash Flow Concept

The Cash Flow Concept is a commonmanagement planning tool.

It distinguishes between:

(a) costs -> cash outflows

(b) revenues/savings -> cash inflows


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Working Capital

Working Capital is: the total value ofgoods and money necessary to maintain

project operations

It includes items such as:

Raw materials inventory Product inventory

Accounts payable/receivable

Cash-on-hand


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Salvage Value

Salvage Value is the resale value ofequipment or other materials at the

end of the project


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Timing of Cash Flows

Workingcapital

Annual Operating CostsAnnual Tax Payments

Annual FinancingPayments

Salvage Value

End of project:

Time zero:

Initial InvestmentWorking Capital

TIMEYear 1 Year 2 Year 3

Annual Revenues/Savings


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Analysis Structure

There are two basic ways to structurea project financial analysis:

1) Stand-alone analysisConsiders only the cash flows of the proposedproject

2) Incremental analysisCompares the cash flows of the proposedproject to the business as usual cash flows


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Incremental Analysis for CP

y For many CP projects, you will needto do an incremental analysis

compare the CP cash flows to thebusiness as usual cash flows

yYou only need to estimate the cashflows that change when you improve

the business as usual operations


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Profitability IndicatorsA profitability indicator, or financialindicator, is: a single number that iscalculated for characterisation of

project profitability in a concise,understandable form.Common examples are:

Simple Payback

Return on Investment (ROI)

Net Present Value (NPV)

Internal Rate of Return (IRR)


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Simple Payback

This indicator incorporates: the initial investment cost

the first year cash flow from theproject

SimplePayback

(in years)

Initial Investment

Year 1 Cash Flow

=


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How to Interpret

Simple PaybackThe simple payback or ROI calculatedfor a project are usually compared toa company rule of thumb called ahurdle rate:

e.g., if the payback period is lessthan 3 years, then the project isviewed as profitable


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The Time Value of Money

andNet Present Value (NPV)


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Question:

If we were giving away money,

would you rather have:(A) $10,000 today, or(B) $10,000 3 years

from nowExplain your answer...


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Inflation

Money loses purchasing power over timeas product/service prices rise, so adollar today can buy more than a dollar

next year.

costs $1 costs $1.05

inflation 5%

nownownext yearnext year


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Investment Opportunity

A dollar that you invest today will bringyou more than a dollar next year having the dollar now provides you withan investment opportunity

Interest, orreturn on investment

Investing$1 now

InvestmentGives you

$1.10 a year

from now


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Time Value of Money (TVM)

y Money now is worth more thanmoney in the future becauseof:

a) inflationb) investment opportunity

y The exact time value of yourmoney depends on themagnitude of the:a) rate of inflation andb) rate of return on investment


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Comparing Cash Flows

from Different Yearsy Before you can compare cash flows

from different years, you need to

convert them all to their equivalentvalues in a single year

y It is easiest to convert all project

cash flows to their present valuenow, at the very beginning of theproject


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Converting Cash Flows

to Their Present ValueyYou can convert future year cash

flows to their present value using a

discount rate that incorporates: Desired return on investment

Inflation

y The discount rate calculation is simple mathematically, it is the reverse ofan interest rate calculation


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Invested at an interest rate of 20%, howmuch will $10,000 now be worth after 3years?

Afteryear

1 $10,000 x 1.20 = $12,000

2 $10,000 x 1.20 x 1.20 = $14,400

3 $10,000 x 1.20 x 1.20 x 1.20 = $17,280

Note: these calculations are on a compound basis

Interest Rate Calculation


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The discounting calculation is essentiallythe opposite of the interest ratecalculation.

If you want to have $17,280 in 3 years,how much would you have to invest now?

$17,280 = $10,000

1.20 x 1.20 x 1.20 needed now

In other words, $17,280 in year 3 has apresent value of $10,000

Discounting Calculation


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Which Discount Rate? (1)

y The discount rate a company choosesshould be equal to the required rate ofreturn for the project investment

y The required rate of return will usuallyincorporate three distinct elements: A basic return - pure compensation for

deferring consumption

Any risk premium for that projects risk Any expected fall in the value of money over

time through inflation


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Which Discount Rate? (2)

y At a minimum, the chosen discount rateshould cover the costs of raising theinvestment financing from investors or

lenders (i.e. the companys cost ofcapital)

y Often, rather than trying to identify theexact source of capital (and its associated

cost) for each individual project, a firmwill develop a single Weighted AverageCost of Capital (WACC) that characterisesthe sources and cost of capital to thecompany as a whole.


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Present Value Factors

Value of $1 in the future, NOWDiscount rate (d): 10% 20% 30% 40%

Years into future (n)

1 .9091 .8333 .7692 .7142

2 .8264 .6944 .5917 .5102

3 .7513 .5787 .4552 .3644

4 .6830 .4823 .3501 .2603

5 .6209 .4019 .2693 .1859

10 .3855 .1615 .0725 .0346

20 .1486 .0261 .0053 .0012

30 .0573 .0042 .0004 .0000


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Net Present Value (NPV)

yNet Present Value (NPV) = the sum ofthe present values of all of a projectscash flows, both negative (cash

outflows) and positive (cash inflows)yNPV characterises the present value ofthe project to the company

If NPV > 0, the project is profitable

If NPV < 0, the project is not


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Estimating

Net Present Value

ExpectedFuture Cash

Flows

- $105,000

+ $38,463

+ $38,463

+ $38,463

PV

Factor

Present Value ofCash Flows

(at time zero)

- $???

$???

$???

$???

$???

Year

0

1

2

3

*=

???

???

???

???

Sum = the projects Net Present Value =


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Interpreting Profitability

Indicators


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Interpret Profitability

Indicators With Caution...

Interpret Profitability

Indicators With Caution...y We have seen that Simple Payback has

some limitations as a project

profitability indicatory Be aware of the advantages and

limitations of the indicators you use


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Some Good Reasons to Use a

Longer Analysis Time Horizon

Some Good Reasons to Use a

Longer Analysis Time Horizony Some out-year costs may be missed if the

time horizon is too short, e.g., a required

wastewater treatment plant upgrade in thefuture

y Some annual operating costs may changesignificantly over time, e.g., disposal fees at

landfillsy Short time horizons neglect the impact of the

time value of money, especially in times ofsignificant inflation, deflation, changing cost

of capital, etc.


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SensitivityAnalysis

y In the absence of a reliable estimateof a companys cost of capital, the

best approach is to do the financialanalysis with several reasonablevalues, to illustrate a correspondingrange of results.

y This type of sensitivity analysis canalso be done if other data in theanalysis are uncertain.


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ProfitabilityAssessment

Tips

Be sure to: Include all relevant and significant

costs/savings in the profitability analysis Think long-term (or at least medium-term!)

Incorporate the time value of money

Use multiple profitability indicators Perform sensitivity analyses for dataestimates that are uncertain


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How to Interpret

Simple Payback and ROIy The simple payback or ROI calculated

for a project are usually compared to

a company rule of thumb called ahurdle rate: e.g., if the project payback period is less

than 3 years, then the project is viewedas profitable

e.g., if the ROI is 33%, then the projectis viewed as profitable


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Net Present Value (NPV)y NPV is a more reliable profitability

indicator that considers both the time

value of money and all future yearcash flows

y NPV = the sum of the discounted cash

flows over the lifetime of the project,using the companys cost of capital asthe discount rate


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How to Interpret NPV

y NPV is calculated over a chosen timehorizon(s), e.g., 5 years

y If the calculated NPV is greater thanzero, the project is profitable overthat time horizon

y

If the calculated NPV is less thanzero, the project is not profitableover that time horizon

financial feasibility 10a

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