Financial Analysis

You need to know how to calculate costs and benefits when you conduct preliminary investigations, evaluate projects, and make recommendations to management

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Objectives of the sessions

1. Understand the steps in conducting a Financial Analysis2. Identify the costs3. Identify the benefits4. Assess the financial indicators to determine if the

project is financially favourable.

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Defining Costs

• Capital costs

• Operating costs

• Development costs

• Operational costs

• Maintenance costs

By type:

By behaviour:

By time:By function:

• Recurring costs

• Non-recurring costs

There are different ways of defining costs:

Variable costs change in proportion to the amount of output produced.

Fixed costs remain the same, no matter how much the business produces.

Direct costs are costs which can be identified directly with the production of a good or service; e.g. raw materials.

Indirect costs are costs which cannot be matched against each product because they need to be paid whether or not the production of good or services takes place; e.g. rent on the premises

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Capital Costs

Capital costs are the expenses incurred in purchase of items that are recorded as assets; their value is depreciated over time and they are recorded in the Balance Sheet.

*Non-consumable materials are capital costs because these are materials that persist (eg. furniture, bricks)

• Equipment • Non-consumable materials*• Infrastructure

Are you able to identify the capital costs for your organisation for the following items:

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Revenue or Operating Costs

Operating costs are expenses incurred in the execution of the project or in the operation of the business (after the project) They are not depreciated over time and are recorded in the profit and loss statement.

*Consumable materials are operating expenses because they are materials that are used up by the project (eg. stationery, batteries)

• Internal business resources• Internal IT resources• External resources• Office accommodation• Licenses• Support

• Training • System administration• Equipment hire• Consumable materials*• Travel• Accommodation

Identify the operating costs for your organisation:

Cost allocationThe process of identifying, aggregating, and assigning costs to cost objects.

A cost object is any activity or item for which you want to separately measure costs. Examples of a cost object are a product, a research project, and a department.

Cost allocation is used for financial reporting purposes, to spread costs among departments or inventory.

Allocating variable costs: straightforward. - based on volumetric measures. (w.r.t. output)

Allocating fixed costs: more difficult. --many joint or common costs, no unique method. Costs should be allocated to those who cause them.

Direct costs can be physically traced to each department Indirect costs must be allocated

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Identifying the benefits

There are two types of benefits:

• Tangible benefits: where the £ value of the benefit can be easily assigned because values are readily measurable.

• Intangible benefits: where the £ value of the benefit is not able to be assigned.

Identify the benefits that the project will provide, and the value that can be assigned to each benefit.

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Examples of tangible benefits

• Reduce labour costs• Reduce equipment expense• Reduce space & overhead costs• Reduce inventory carrying expense• Reduce accounts receivable & bad debts• Increase sales by 10%

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Examples of intangible benefits

• Improve customer service• Make better business decisions• Increase market share• Better managed resources• Improve company image

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How are benefits identified…

• The sponsor of the project is the best person to identify the benefits. The sponsor owns the benefits.

• Consult with a number of different areas that are going to be impacted by the solution to identify additional benefits

• Brainstorming is a useful technique for identifying possible benefits.

Capital budget decision making

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Investment appraisal methods:An important step in the capital budgeting cycle 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.2

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Payback Method

• Assume that an organisation is considering buying some equipment (Machine 1) for £210,000, with an estimated useful life of 11 years, and zero predicted residual value.

• Managers expect use of the equipment to generate £35,000 of net cash inflows from operations per year.

How long would it take to recover the investment?

Payback Method

• How long would it take to recover the investment?

• £210,000 ÷ £35,000 = 6 years• 6 years is the payback period.

Payback Method

• Suppose that an alternative to the £210,000 piece of equipment, there is another one (Machine 2) that also costs £210,000 but will save £42,000 per year during its five-year life.

• What is the payback period?• £210,000 ÷ £42,000 = 5 years• Which piece of equipment is preferable?

Payback Method

• Machine 1 is preferable because it will continue to generate net cash inflows for four years after its payback period.

• This will give the company an additional net cash inflow of £140,000.

Payback Method

• When cash flows are uneven, calculations must take a cumulative form.

• Assume that an organisation’s investment is going to yield net cash savings of £160,000, £180,000, and £110,000 over its life.

• The initial investment is £250,000.• What is the payback period?

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Payback Method

• Year 1 brings in £160,000. • Recovery of the amount invested occurs in

Year 2.

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Payback Method

• Payback= 1 year+ £90,000 needed to complete recovery

£180,000 net cash inflow in Year 2• 1 year + 0.5 year = 1.5 years or,• 1 year and 6 months

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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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Advantages of ARRAs with the Payback method, the chief advantage with ARR is its simplicity. There is also a link with some accounting measures that are commonly used. The Average Rate of Return is similar to the Return on Capital Employed in its construction; this may make the ARR easier for business planners to understand. The ARR is expressed in percentage terms and this, again, may make it easier for managers to use.

Arguments against ARRFirstly, the ARR doesn't take account of the project duration or the timing of cash flows over the course of the project.Secondly, the concept of profit can be very subjective, varying with specific accounting practice and the capitalisation of project costs. As a result, the ARR calculation for identical projects would be likely to result in different outcomes from business to business.Thirdly, there is no definitive signal given by the ARR to help managers decide whether or not to invest. This lack of a guide for decision making means that investment decisions remain subjective

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A project requires a capital outlay of £900 000 and earns the following cash inflows over the following seven years (all £k):

Year 1 2 3 4 5 6 7

Inflows 200 250 300 450 400 200 150

Calculate the project's payback period.

Calculate the Average Rate of Return for the project.

Try these questions

Average Rate of Return

ARR = (Average annual profits / Initial capital costs) * 100ARR = (£278 571 / £900 000) * 100= 0.30952 * 100= 31 %

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Payback occurs during Year 4. £450 000 revenues are generated in Year 4. Because £150 000 remained to be paid off at the start of Year 4, the payback period is 3 Years + 150/450 = 1/3 rd of a year.

Payback = 3 1/3rd years = 3 years and 4 months

Year 0 1 2 3 4 5 6 7

Inflows (900) (700) (450) (150) 300 700 900 1050

PaybackThe cumulative cash flows are detailed below:

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 future.

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Discounted Cash Flow

There are two main DCF methods:1 Net present value (NPV) method2 Internal rate-of-return (IRR) method

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The Value of Money

• The value of money changes over time.

• With most projects, the financial benefits are realised at a different

time to the costs.

• Net present value (NPV) provides a means to compare these by

adjusting the value to today’s value.

• This is achieved by modifying the future value by a factor that

represents the change in value of money from today’s value.

• This factor is called the discount factor.

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• If you receive cash you are quite likely to save it and put it in the bank.

• What a business sacrifices by having to wait for the cash inflows is the interest lost on the sum that would have been saved.

• NPV is a technique where cash inflows expected in future years are discounted back to their present value.

• This is calculated by using a discount rate equivalent to the interest that would have been received on the sums, had the inflows been saved, or the interest that has to be paid by the firm on funds borrowed.

Net Present Value - NPVImagine you have £66080 and invest this at 10% rate. After two years you would receive approx £80000

£60080 and invest this at 10% rate. After three years you would receive approx £80000

Looking from a different point of view – imagine you received £80k in three years

What is this worth at today’s value Need to discount this to its present value at the rate we could have expected i.e. 10%

NPV = Sum of all PV’s less initial investment

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Present Value

We will simply use a table to obtain multiplication factor

Net Present Value - NPV £60080 and invest this at 10% rate. After three years you would receive approx £80000

Looking from a different point of view – imagine you received £80k in three years

What is this worth at today’s value Need to discount this to their present value at the rate we could have expected i.e. 10% Multiplication factor from the table: 0.751Therefore £80k at today’s value = £80k x 0.751 = £60080

Net Present Value

Cash Flows

Net initial investment (£250,000)

Annual cash inflow £125,000 £130,000 £115,000

0 1 2 3

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Net Present Value Year 10% Inflows Net Cash Inflows

1 0.909 £125,000 £113,625 2 0.826 130,000 107,380 3 0.751 115,000 86,365

Total PV of net cash inflows £307,370 Investment £ 250,000 Net present value of project £ 57,370

• This project is acceptable because its net present value is positive at £57,370.

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Net Present Value

• Assume the organisation is considering another investment that will generate £80,000 per year for three years, and have a residual value of £4,000 at the end of the third year

• The cost of this investment is £250,000 including working capital.

• The working capital investment of £5,000 is expected to be recovered at the end of year 3.

• Our Organisation expects a return of 10%.• Should the investment be made?

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Net Present Value Year 10% Inflows Net Cash Inflows

1 0.909 £80,000 £72,720 2 0.826 80,000 66,080 3 0.751 80,000 60,080 3 0.751 (4000+5000) 9,000 6,759

Total PV of net cash inflows £ 205,639 Investment £ 250,000 Net present value of

project (£ 44,361)

• No, the net present value is negative.

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NPV Exercise

Calculate NPVWhy is NPV Important?

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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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The Internal Rate of Return (IRR)

A positive NPV is produced by our DCF calculations, a project is worthwhile. When there are competing projects, we should select the one that produces the highest NPV.

But sometimes a firm will want to know how well a project will perform under a range of interest rate scenarios.

The aim with IRR is to answer the question: 'What level of interest will this project be able to withstand?' Once we know this, the risk of changing interest rate conditions can effectively be minimised.

The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested.

Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero. 38

Making the investment decisionLet's set out the criteria for accepting or rejecting investment opportunities, using the NPV and IRR.Imagine a scenario where the managers of a firm are considering whether to accept or reject an investment project, on the basis of their acquiring the funds necessary at a known rate of interest.The NPV approach asks if the present value of cash inflows less the initial investment is positive, at the current borrowing rate.The IRR approach asks if the IRR on the project is greater than the borrowing rate

Illustration of NPV & IRRAn initial investment of £ 2 500 in a project produces cash inflows of £ 750, £ 750, £ 900, £ 900 and £ 595 at 12 month intervals. The cost of capital to finance the project is 12 %.You are required to decide whether the project is worthwhile using:The Net Present ValueThe Internal Rate of Return

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Year 0 1 2 3 4 5

Cash flow (2500) 750 750 900 900 595

NPV The cost of capital to finance the project is 12 %.

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Year Cash flow Discount factor @ 12%

Present value

0 (2500) 1.000 (2500)

1 750

2 750

3 900

4 900

5 595

Net present value

NPV A positive NPV makes the project worthwhile because the cost of

tying up the firm's capital is compensated for by the cash inflows that result.

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Year Cash flow Discount factor @ 12%

Present value

0 (2500) 1.000 (2500)

1 750 0.893 669.75

2 750 0.797 597.75

3 900 0.712 640.80

4 900 0.636 572.40

5 595 0.567 337.37

Net present value

£318.07

IRRThe calculation for NPV used a 12 % discount rate and produced a positive value of £ 318.07. We need to find a discount rate that produces a negative NPV. Let's try 20 %.

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Year Cash flow Discount factor @ 20%

Present value

0 (2500) 1.000 (2500)

1 750

2 750

3 900

4 900

5 595

Net present value

IRRThe calculation for NPV used a 12 % discount rate and produced a positive value of £ 318.07. We need to find a discount rate that produces a negative NPV. Let's try 20 %.

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Year Cash flow Discount factor @ 20%

Present value

0 (2500) 1.000 (2500)

1 750 0.833 624.75

2 750 0.694 520.50

3 900 0.579 521.10

4 900 0.482 433.80

5 595 0.402 239.19

Net present value

(£160.66)

The IRR lies between 12 % and 20 %. But we can get much closer to the precise answer by using arithmetic.

IRR = 12 % + (Difference between the two discount rates )* (Positive NPV / Range of +ve to -ve NPVs)

IRR = 12 % + (8 % * 318.07) 478.73 IRR = 12 % + 5.32IRR = 17.32 %

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IRR Summary:The value to a business of calculating the IRR is that its decision-makers are able to see the level of interest that a project can withstand.

In the case where a number of projects are competing for selection, the one that is most resilient can be chosen.

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Comparison of NPV and IRR

• The NPV method has the important advantage that the end result of the computations is expressed in pounds and not in a percentage.

• Individual projects can be added to see the effect of accepting a combination of projects.

• It can be used in situations where the required rate of return varies over the life of the project.

• The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.

Note: Excel has NPV and IRR functions

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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

Average Rate of Return

► Easy to compute ►Ignores the time value of money

Summary and Conclusions•A capital budgeting decision involves planning cash flows for a long-term investment•Several methods are used to analyse investment proposals e.g. payback, net present value, internal rate of return•The net present value method, in particular, considers the amount and timing of cash flows•The analysis is based upon estimates of incremental cash flows after tax that will result from the investment

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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.

'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