Project Assessment

Essentials of Corporate Finance

Chapters 4, 8, 9, 12

Materials Created by Glenn Snyder – San Francisco State University

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 2

Topics

Internal Financial Analysts The Importance of Internal Analysts

Investment Pool Funding Criteria and Project Types Projections Cost of Capital IRR vs. NPV Scenario Analysis Business Impact Decision Making

Career Advice for an Internal Financial Analyst

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 3

Internal Financial Analysts

An Internal Financial Analyst is a member of the Finance organization that works to analyze, consult, project, and generate ideas to make the company more financially sound.

Internal Financial Analysts usually work in groups called: Financial Planning & Analysis Corporate Planning & Development Finance Business Partners

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 4

The Importance of Internal Financial Analysts Internal Financial Analysts do:

Budgeting and Variance Analysis Strategic Planning for internal business units Internal Financial Reporting Profitability Analysis Growth and Trend Analysis Liaising between Finance and other business units Strategic Project Analysis

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 5

Investment Pool Funding

Investment Pools are funds the company sets aside at the beginning of the fiscal year for strategic projects

Senior Finance and business leaders make up the Investment Pool Committee and decide which projects the company is willing to take on, and which ones will be put on hold.

Internal Financial Analysts typically Organize and summarize all of the requests Provide insight to the Investment Pool Committee Assist business units in constructing their proposals Track and report on expenses and revenues after the projects

are approved

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 6

Investment Pool Funding

When a project is submitted to the Investment Pool, it would include: Description of the project Description of the need Cost projections for the project Additional non-direct project costs / resources Benefits to the organization IRR / NPV Analysis Scenario Analysis Time schedule of milestones and estimated completion

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 7

Criteria and Project Types

To apply for Investment Pool Funding, the project has to cost more than the minimum threshold, e.g. $500,000.

Strategic Projects include: System Upgrades and Purchases Small Acquisitions Strategic Initiatives

Companies can easily have over 300 Investment Pool projects going at one time Many more projects can be submitted and not approved

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 8

Projections

Cost and Benefit Projections Cost Projections would include:

Direct Costs – Actual costs to do the project Indirect Costs – Support costs from other areas of the

company (e.g. HR, Finance, IT, etc.) Benefit Projections would include:

Impact to net revenue Impact to sales Impact to market share and/or competitors Efficiency gains and how they equate to the bottom line Impact to the organization beyond the project’s life

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 9

Cost of Capital

Most companies don’t calculate (or even know) their cost of capital Typically, the company uses a standard or average

rate, such as 12% for the cost of capital

Why don’t companies use their actual cost of capital? The rate could change every month It would require resources to constantly update the cost of

capital It would add confusion to the business units that submit

multiple projects using similar templates/forms.

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 10

IRR vs. NPV

Most companies prefer to see some kind of ROI (return on investment) calculation Since ROI is stated as a rate (Return on

investment), IRR is the calculation used the most Many companies use both IRR and NPV, as NPV

is much easier to understand

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 11

IRR vs. NPV

Problems with IRR and NPV Many times, a business unit is not aware of all of

the costs (indirect in particular) that go into a project Thus, the IRR is badly overstated (e.g. 600% returns)

Corporations try to simplify the process to get information that is directionally correct 80 / 20 rule – 80% of the answer for 20% of the effort

When the business unit that wants the project approved submits the projections and analysis, the data is often much to favorable for the project

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 12

Scenario Analysis

Each project should be presented in three scenarios: Best Case – What would happen if everything went

perfectly Worst Case – What would happen if little went right Most Likely Case – The case that the business truly thinks

will happen

Sometimes, the best case scenario, may be the worst for cash flow. Projects that drastically increase sales, may constrain

cash flow and require financing, which is an additional cost.

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 13

Business Impact

Many projects get approved not on their financial contribution, but their impact to the business. Upgrade from Windows 2000 to Windows XP

This upgrade could cost a company millions, but will not enhance revenue or sales

Enhancements to a customer service call center These enhancements may be in new systems or

personnel They may not generate revenue, but keep existing

clients from leaving

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 14

Decision Making

The Investment Pool Committee must decide which projects will have the greatest impact on the organization. Financial Impact

Increase Revenue Reduction of Expenses

Efficiency Impact Greater production from existing resources

Market Impact Positive public awareness

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 15

Decision Making

The senior management team that makes up the Investment Pool Committee is often rated based on the impact of the projects they approve

Incentive to pick the best projects for the organization Strong projects can add to a senior manager’s bonus and

rating at year-end

Senior managers must be careful not to play favorites with projects submitted from their divisions Many cases there are conflicts of interest, which is why the

decisions are made by a committee and not an individual

February 26, 2007

Materials Created by Glenn Snyder – San Francisco State University 16

Career Advice for an Internal Financial Analyst Skills required to be a successful internal financial analyst

Adaptability – Be willing and able to adapt to an ever-changing environment

Intelligence – The faster you can learn, the more value you can add to the company

Creativity – The ability to be able to develop new ideas and solutions

Career Path for an Internal Financial Analyst Just about anything

Internal Financial Analysts are exposed to many areas of the company and build skills that apply just about everywhere

Many companies offer management training programs