Evaluation of Financial feasibility of

CP options

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Project Cash Flows
and
Simple Payback

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 The Cash Flow Concept
The Cash Flow Concept is a common
management planning tool.

It distinguishes between:

(a) costs -> cash outflows

(b) revenues/savings -> cash inflows
 Types Of Cash Flows
Outflow Inflow
Initial Equipment
One-time investment salvage
cost value
Operating Operating
Annual costs & revenues
taxes & savings
Working Working
Other capital capital
 Working Capital

Working Capital is: “the total value of

goods and money necessary to maintain
project operations”

It includes items such as:

– Raw materials inventory
– Product inventory
– Accounts payable/receivable
– Cash-on-hand
 Salvage Value

Salvage Value is the resale value of

equipment or other materials at the
end of the project
 Timing of Cash Flows
End of project:
Salvage Value
Annual Revenues/Savings Working
capital

Year 1 Year 2 Year 3 TIME

Annual Operating Costs

Annual Tax Payments
Time zero: Annual Financing
Working Capital Payments
Initial Investment
 Analysis Structure
There are two basic ways to structure
a project financial analysis:
1) Stand-alone analysis
Considers only the cash flows of the proposed
project
2) Incremental analysis
Compares the cash flows of the proposed
project to the “business as usual” cash flows
 Incremental Analysis for CP
 For many CP projects, you will need
to do an incremental analysis —
compare the CP cash flows to the
“business as usual” cash flows
 You only need to estimate the cash
flows that change when you improve
the “business as usual” operations
 Profitability Indicators
A profitability indicator, or “financial
indicator”, is: “a single number that is
calculated 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)
 Simple Payback
This indicator incorporates:
– the initial investment cost
– the first year cash flow from the
project

Simple Initial Investment

=
Payback
(in years) Year 1 Cash Flow
 How to Interpret
Simple Payback
The simple payback or ROI calculated
for a project are usually compared to
a company rule of thumb called a
“hurdle” rate:

e.g., if the payback period is less

than 3 years, then the project is
viewed as profitable
The Time Value of Money
and
Net 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 now
Explain your answer...
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 Inflation
Money loses purchasing power over time
as product/service prices rise, so a
dollar today can buy more than a dollar
next year.

inflation 5%

costs $1 costs $1.05

now next year
 Investment Opportunity
A dollar that you invest today will bring
you more than a dollar next year —
having the dollar now provides you with
an investment opportunity

Investing Gives you

Investment $1.10 a year
$1 now
from now

Interest, or
“return on investment”
 Time Value of Money (TVM)
 Money now is worth more than
money in the future because
of:
a) inflation
b) investment opportunity

 The exact “time value” of your

money depends on the
magnitude of the:
a) rate of inflation and
b) rate of return on investment

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 TVM and Project Profitability

 When you invest in a capital project,

you have:
(1) An initial investment happening NOW
(2) A series of future cash inflows, over
time, that pay back the initial investment

 So, it is important to take the Time

Value of Money (TVM) into account
when you are estimating project
profitability
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 Comparing Cash Flows
from Different Years
 Before you can compare cash flows
from different years, you need to
convert them all to their equivalent
values in a single year
 It is easiest to convert all project
cash flows to their “present value”
now, at the very beginning of the
project
 Converting Cash Flows
to Their Present Value
 You can convert future year cash
flows to their present value using a
“discount rate” that incorporates:
– Desired return on investment
– Inflation
 The discount rate calculation is simple
— mathematically, it is the reverse of
an interest rate calculation
 Interest Rate Calculation
Invested at an interest rate of 20%, how
much will $10,000 now be worth after 3
years?

After
year
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

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 Discounting Calculation
The discounting calculation is essentially
the opposite of the interest rate
calculation.

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 a

present value of $10,000
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 Which Discount Rate? (1)
 The discount rate a company chooses should
be equal to the required rate of return for
the project investment
 The required rate of return will usually
incorporate three distinct elements:
– A basic return - pure compensation for deferring
consumption
– Any ‘risk premium’ for that project’s risk
– Any expected fall in the value of money over time
through inflation

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 Which Discount Rate? (2)
 At a minimum, the chosen discount rate should
cover the costs of raising the investment
financing from investors or lenders (i.e. the
company’s “cost of capital”)
 Often, rather than trying to identify the exact
source of capital (and its associated cost) for
each individual project, a firm will develop a
single “Weighted Average Cost of Capital”
(WACC) that characterises the sources and
cost of capital to the company as a whole.

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 Present Value Factors
Value of $1 in the future, NOW
Discount 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)
 Net Present Value (NPV) = the sum of
the present values of all of a project’s
cash flows, both negative (cash
outflows) and positive (cash inflows)

 NPV characterises the present value of

the 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

Expected Present Value of

Year Future Cash PV = Cash Flows
* Factor
Flows (at time zero)

0 - $105,000 ??? - $???

1 + $38,463 ??? $???
2 + $38,463 ??? $???
3 + $38,463 ??? $???

Sum = the project’s Net Present Value = $???

Interpreting Profitability
Indicators

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 Interpret Profitability
Indicators With Caution...
 We have seen that Simple Payback has
some limitations as a project
profitability indicator
 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 out-year costs may be missed if the
time horizon is too short, e.g., a required
wastewater treatment plant upgrade in the
future
 Some annual operating costs may change
significantly over time, e.g., disposal fees at
landfills
 Short time horizons neglect the impact of the
time value of money, especially in times of
significant inflation, deflation, changing cost
of capital, etc. 30
 Sensitivity Analysis
 In the absence of a reliable estimate of
a company’s cost of capital, the best
approach is to do the financial analysis
with several reasonable values, to
illustrate a corresponding range of
results.
 This type of sensitivity analysis can also
be done if other data in the analysis
are uncertain.
Profitability Assessment 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 data
estimates that are uncertain
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 How to Interpret
Simple Payback and ROI
 The simple payback or ROI calculated
for a project are usually compared to a
company rule of thumb called a “hurdle”
rate:
– e.g., if the project payback period is less
than 3 years, then the project is viewed
as profitable
– e.g., if the ROI is 33%, then the project
is viewed as profitable
 Net Present Value (NPV)

 NPV is a more reliable profitability

indicator that considers both the time
value of money and all future year
cash flows
 NPV = the sum of the discounted cash
flows over the lifetime of the project,
using the company’s cost of capital as
the discount rate
 How to Interpret NPV

 NPV is calculated over a chosen time

horizon(s), e.g., 5 years
 If the calculated NPV is greater than
zero, the project is profitable over
that time horizon
 If the calculated NPV is less than
zero, the project is not profitable
over that time horizon