financial evaluation of projects

7/28/2019 Financial Evaluation of Projects

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Enlighten.Me [email protected]

http://enlightenmetraining.wordpress.com/

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Why do a financial evaluation?

An economic valuation of a project may be complex, but the reason

for doing one is simple. It is to answer one question :

In comparison to the alternative options, such as differentresources, different locations, different technology, different

schedules or even doing nothing...

Does this project represent the best possible

value for money?


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In receivership after less than a year!


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How many thousand cars per day?

27

59 60

100110

135

Average No toll Opening 2012 2014 2026

ForecastActual


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How do you value a project?

The most common way of valuing a project is to determine the net

present value (NPV) of its cash flows.

Consider all the money that will be spent or earned on a particularproject and calculate the value of that money in todays terms.

NPV =FVt

(1 +i)tNt=0


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Discounting

Lunch and Learn Economic Valuation of Projects

To value a future cash flow in todays terms we need to discount it.

This is where we answer questions like If we receive $5m in 6 years

time, what is that worth today?

We apply a discount rate against each cash flow and factor in the

number of periods it occurs in the future.

NPV =FVt

(1 +i)tNt=0


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What rate do we use?


The discount rate can consider things such as :

The cost of finance (interest or WACC),

Risk or

Required rate of return.

NPV =FVt

(1 +i)tNt=0


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Cash is king!

When performing an NPV calculation, we always work with

cash flows.

Usually we focus on the following four cash flows : Sales (Quantity x price)

Capital expenditure (Buildings, Software, Hardware)

Operating expenditure (Salaries, Maintenance, Electricity)

Tax (Income tax, other taxes or concessions)


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Calculating NPV


NPV =FVt

(1 +i)tNt=0

If we add the present value of the cash flow for every year, we get

the present value of a project. Greater than zero is the goal!

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

- $1,000 -$100 $200 $500 $800 $600 $400

-$ 909

-$ 83

$ 150

$ 342

$ 497

$ 339

$ 205$ 541

Value in todays terms

(discounted at 10%)

10%


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Calculating IRR


NPV =FVt

(1 +i)tNt=0

The rate at which NPV = zero is the internal rate of return (IRR).

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

- $1,000 -$100 $200 $500 $800 $600 $400

-$ 813

-$ 66

$ 108

$ 219

$ 285

$ 174

$ 94$ 0

IRR is the rate at which the NPV = zero

22.93%

= 0


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Simple example


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Dealing with uncertainty

Determining the exact amount of cash a project is going to generate

is not easy. Its probably impossible.

We should have a plan for considering the impact of thisuncertainty.

3 common approaches are

Do nothing

Build a Low, Medium and High Case

Build a probalistic model


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What are the chances?

What are the odds of flipping tails with a coin?

What are the odds of flipping tails three times in a row?


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Money has a shelf life


It is much better to have $1,000

today than tomorrow.

Why is this important?

It is much better to have positivecash flows earlier in a project (and to

try and delay cash outflows)

Time is money Benjamin Franklin


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Dont forget about tax


Most people know that tax reduces

the amount you earn, but dont

forget about the benefits.

Why is this important?Changing capital costs will not

deliver the entire cost increase or

saving as you will gain or lose on tax

too.

This is too difficult for a mathematician.It should be asked of a philosopher.Albert Einstein (filling out his tax return)


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Beware the butterfly effect


Evaluation models are often complex

and involve multiplying costs by cost

drivers. There is a risk a small change

can have a big impact on value.Why is this important?

While working in a model, you must

constantly track that the impact on

NPV is expected and acceptable.

Change one thing, change everything.Tagline for the movie The Butterfly Effect


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Change control is your friend


Record changes to assumptions and

their impact on value in a model.

Why is this important?As models are generally fairly complex,

it is easy to get lost and forget what

has been included in the model and

excluded from the model.

It is not the strongest of the species that survive, nor the most intelligent, butthe one most responsive to change.Charles Darwin


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Excel does not always equal Excellent


A complex financial model means high

probability for human error. These can

be inconsequential, but they can also

lead to the wrong decision.Why is this important?

Check and review your financial

models. Develop expectations on value

and challenge the output.

The good news about computers is they do what you tell them to do. The badnews is that they do what you tell them to do.Ted Nelson


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The model is one chapter in the story


The financial evaluation is just one

component of the final decision.

Why is this important?The model itself does not generate an

answer. You must understand the

various options being considered and

the qualitative impacts of them.

The only people who see the whole picture are the ones whostep out of the frame.Salman Rushdie, The Ground Beneath Her Feet


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