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Introduction

► This slide deck provides a suggested framework for the financial evaluation of an investment project. When evaluating any such project, the decision to proceed should occur within the broader decision making process of your business.

► To ensure the successful implementation of any new investment proposal / project you should, as a minimum:

– Produce a detailed cash flow of each alternative (where there are alternatives)

» Ensure that all costs and benefits are included

– Undertake the financial appraisal of each

– Implement and monitor the performance of the project

Cost AnalysisWhere possible all costs and expected benefits resulting from this opportunity should be analysed for each viable alternative (including the costs and benefits of status quo).

Any detailed worksheets should be attached as an appendix, with relevant data within the body of the Financial Case

Timeframe: Identify an appropriate project timeframe over which both the cost and benefits will be analysed.

Timeframe should be appropriate to the expected lifecycle of the project, from incurring costs to achieving the anticipated benefits.

AssumptionsAssumptions around costs, benefit calculations and resource availability should be included business cases.

Costs: Identify all relevant costs incurred over the chosen project timeframe:

Direct costs

Indirect costs

Initial costs

On-going costs

Capital costs

Consideration should be given to:

When the costs will be incurred

Who will incur the costs

Certainty of costs

Benefits:

Identify all quantifiable benefits over the chosen project timeframe.

Consideration should be given to:

When the benefits will be achieved

Who will be the recipient of the benefits

Certainty of benefits

Type of Cost Year 1 Costs

Year 2 Costs

Year 3 Costs

Year 4 Costs

Year 5 Costs

Operating Expenses

Internal business resources

Internal IT resources

External resources

Office accommodation

Licenses

Support

Training

System administration

Equipment hire

Consumable materials

Travel

Accommodation

Other

Capital Expenses

Equipment

Non-consumable Materials

Infrastructure

Other

Total

Cost Estimate per option

Cost Assumptions:1.2.3.

Tangible Benefits Year1 Year 2 Year 3 Year 4 Year 5

Increased Revenue from….

Cost Savings from…

Other…

Total

Tangible Benefits Assumptions:1.2.3.

Benefits per option

Intangible benefits would also be considered in overall business decision making

Year Cash Flow (£) Option 1

Cash Flow (£) Option 2

Cash Flow (£) Option 3

0 (cost/investment) (cost/investment) (cost/investment)

1 In-flow In-flow In-flow

2 In-flow In-flow In-flow

3 In-flow In-flow In-flow

4 In-flow In-flow In-flow

5 In-flow In-flow In-flow

Cash Flows

The decision may simply be a go / no-go for a project/investment or there may be various alternatives from which to choose.

Investment appraisal methods:An important step in the investment decision is working out if the benefits of investing large capital sums outweigh the costs of these investments.Two methods: -

Traditional methods; include the Average Rate of Return (ARR) and the Payback method

Discounted cash flow (DCF) methods use Net Present Value (NPV) and Internal Rate of Return (IRR) techniques

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Traditional MethodsPayback:This is literally the amount of time required for the cash inflows from a capital investment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period. Payback is often used as an initial screening method.Payback period = Initial payment / Annual cash inflowThe shorter the payback period, the better the investment

Payback summaryIt is probably best to regard payback as one of the first methods you use to assess competing projects. It could be used as an initial screening tool, but it is inappropriate as a basis for sophisticated investment decisions.

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Average Rate of Return:Average rate of return expresses the profits arising from a project as a percentage of the initial capital cost. The definition of profits and capital cost are different depending on which textbook you use e.g. the profits may be taken to include depreciation, or they may not.

One of the most common approaches is as follows:ARR = (Average annual revenue / Initial capital costs) * 100

A simple example to illustrate the ARR:A project to replace an item of machinery is being appraised. The machine will cost £240 000 and is expected to generate total revenues of £45 000 over the project's five year life. What is the ARR for this project?ARR = ((£45 000 / 5) / 240 000) * 100= (£9 000/ 240 000) * 100= 3.75%

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Discounted Cash Flow

• Discounted cash-flow (DCF) methods measure all expected future cash inflows and outflows of a project as if they occurred at a single point in time.

• The discounted cash-flow methods incorporate the time value of money.

• The time value of money means that a pound received today is worth more than a pound received at any future time.

• Why?• Because it can earn income and become greater in the

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Net Present Value

• The NPV method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present point in time, using the required rate of return.

• Management’s minimum desired rate of return is also called the discount rate, hurdle rate, required rate of return, or cost of capital.

• Only projects with a zero or positive net present value are acceptable

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Is defined as the discount rate at which an investment has a zero net present value.

The internal rate of return equates to the interest rate, expressed as a percentage, that would yield the same return if the funds had been invested over the same period of time.

Therefore, if the internal rate of return for the project is less than the current bank interest rate it would be more profitable to put the money in the bank than execute the project

Internal Rate of Return

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Option 1 Option 2 Option 3 Option 4

Discount Rate

Net Present Value

Internal Rate of Return

Payback Period in Years

Average annual rate of return

Financial Evaluation

Return On Investment - ROI

Return on capital employed - ROCE

You can also considering the following if appropriate

'Return On Investment - ROI' A performance measure used to evaluate the efficiency of an investment

or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

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Return on capital employedROCE is sometimes referred to as the "primary ratio”. It tells us what returns (profits) the business has made on the resources available to it

ROCE = Net Operating Profit

Capital Employed

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Sensitivity Analysis

Projects do not always run to plan. Costs and benefits estimated at an early stage of a project may indicate a profitable project, but this profit could be eroded by an increase in costs or a decrease in the value of the benefits (the revenue).

Sensitivity analysis provides a means of determining the financial impact of this type of fluctuation.

By entering an anticipated percentage increase in costs or decrease in revenue the financial impact on the project can be identified by looking at the change to the NPV or IRR measures.

NPV IRR Payback Period in

Years

Other evaluation methods

Costs increase by xx%

£ %

Revenues decrease by xx%

£ %

Sensitivity Analysis

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Feasibility analysis

Method Benefits Disadvantages

Payback ► Easy to compute► Easy to understand

►Ignores the benefits that occur after the payback period

►Ignores the time value of money

Net present value ► Accounts for changing value over time, i.e. time value of money

►Need to select an appropriate discount rate

Internal Rate of Return

► Provides a benchmark for what should and should not be invested in

►Need to select an appropriate benchmark IRR

►Doesn’t give an indication of the absolute value of a project

Accounting Rate of Return

► Easy to compute ►Ignores the time value of money

In order to reach a reasoned conclusion analysis should be undertaken for each option .

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Summary► Selecting which projects to undertake can be done by comparing

the different investment appraisal metrics for each project providing they have all been prepared on a consistent basis

► Ideally all the investment appraisal metrics should be considered

• Using one metric in isolation could lead to misleading results and potentially incorrect decisions being made

• Once the cash flows have been prepared, all metrics should be easy to calculate

► NPV, IRR, Payback and ARR are all financial metrics.