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Chapter 8Financial Evaluation

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The Decision-Making Model.

CRITERIACRITERIA

NON-FINANCIAL ANALYSISNON-FINANCIAL ANALYSIS FINANCIAL ANALYSISFINANCIAL ANALYSIS

PROBLEM STATEMENTPROBLEM STATEMENT

ALTERNATIVESALTERNATIVES

MAKE A CHOICEMAKE A CHOICE

IMPLEMENTATION PLAN & FOLLOW UP

IMPLEMENTATION PLAN & FOLLOW UP

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Financial analysis is complex

• Financial analysis deserves special consideration for two reasons. – Firstly, it is often regarded as the most

complex part of the evaluation process and – secondly, financial efficiency and

effectiveness are very powerful strategic goals

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REASONS FOR FINANCIAL EVALUATION

– The purpose of this chapter is to enhance your understanding of financial evaluation so that you can:

• initiate and perform financial evaluations in support of the analysis of decision alternatives,

• understand the implications on the business decision of cash flow estimates into the future,

• develop a sufficient understanding of financial analysis to be able to incorporate financial considerations in the business case.

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REASONS FOR FINANCIAL EVALUATION

• There are two objectives of financial evaluation:

• To array• To quantify the expected results

– Financial evaluation is the comparison of investment costs to financial benefits received.

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INVESTMENT COSTS DEFINED

• A cost is defined as a resource used to achieve an objective.

• In general terms, any cost could represent:• an increase or potential increase in capacity• a decrease or potential decrease in operating

costs• a change in processes or procedures for technical

improvement alone• a change in processes or procedures to satisfy

non-quantitative factors.

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INVESTMENT COSTS DEFINED

• There are five key points associated with this definition of investment costs.1. Investment costs are not just capital.

2. Investments represent a change in future conditions.

3. Investments relate to corporate objectives and business unit strategies.

4. Investments deal in a world of uncertainty.

5. Investment benefits and costs are assumed to be quantifiable.

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COST OF CAPITAL DEFINED

• "Cost Of Capital" (also called "hurdle rate") is more appropriately thought of as an opportunity cost of capital.

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COST OF CAPITAL DEFINED

• The investment hurdle rate calculation used by industry is:

The prime lending rate (the rate for rented money)

plus a premium for general economic risk (inflation)

plus a premium for economic risk faced in this industry

plus a premium for risk faced in dealing with assets of this type,

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CASH FLOW ANALYSES

• Time Value of Money

• It is necessary to modify the streams of benefits and costs so that they can be compared at a single point in time. The comparison is termed "Discounted Cash Flow".

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DISCOUNTED CASH FLOW

• The objective is to compare cash streams at a single point in time with reference to the established hurdle rate.

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Simple Interest Example

• An investment is made and the proceeds from interest are withdrawn at the end of each year.

• When considering an investment of $1,000 made at an interest rate of 12% for 5 years, the simple interest return on the investment is:

Simple Interest = P x i x n

Simple Interest = l000 x .12 x 5

Simple Interest = $600

(The simple interest formula assumes that the interest return on the $1,000 is not reinvested.)

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DISCOUNTED CASH FLOW

• Compound Interest Example• Consider this time that the annual return on

our $1000 investment is reinvested. The value at the end of 5 years, where "S" is the compound sum is calculated as follows.

S = P x (l+i)n

S = l000(l+.12)5

S = 1000 x l.76234

S = $1762.34

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DISCOUNTED CASH FLOW

• Present Value Example• In order to conduct an analysis of cash flow into

the future, we need to take a mirror image of “compounding” so that we can see how much value there is today in the prospect of receiving cash some time in the future.

• A series of tables are presented in the following figures for discussion.

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DISCOUNTED CASH FLOW

– Figures 8.2 and 8.3 show the present value of dollars to be received in the future.

– $1.00 to be received in 20 years in a 10% world is the same as $.149 to be received today. $1.00 to be received in 20 years in the 30% world is the same as $.005 today.

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DISCOUNTED CASH FLOW

• Figures 8.4 & 8.5, “Compound Amounts” shows how money accumulates over time using the cost of capital as the investment rate.

• In a 10% world, one dollar will accumulate to $6.727 in 20 years, and in a 30% world one dollar will accumulate to $190.05 in 20 years.

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DISCOUNTED CASH FLOW

• The discount rate or “Opportunity Cost of Capital” incorporates the financial risks of a project in three ways:

• The streams of benefits in the form of either savings or revenues are not entirely predictable.

• The value of money changes in terms of inflationary purchasing power.

• There is some uncertainty about the changing "rental rate" for funds.

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CASH FLOW ESTIMATES

• Keep in mind that "sunk costs" (those relating to an investment that have already been made), are not relevant to the decision at hand.

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Types of Cash Flows

• Cash outflows: (expenditures made to start the project and keep it going for its whole life)– Initial investment– Recurring maintenance costs– Recurring operating costs and negative

benefits– Periodic improvement costs

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Types of Cash Flows

• Cash inflows: (financial benefits received from the project for its whole life)– Incremental Revenues– Incremental Savings– Proceeds on Disposal

• We deal only with cash inflows and outflows that are directly attributable to the decision at hand.

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PRESENT VALUE dollars

FACTOR

ANNUAL CASH INFLOWS

0 1 2 3 4 5

INITIAL INVESTMENT

400,000 1.000 (400,000)

Present value of annual cash

flows

136,350 .909 150,000

123,900 .826 150,000

112,650 .751 150,000

102,450 .683 150,000

93,150 .621 150,000

TOTAL BENEFITS

568,500 (sum of the present values of cash inflows)

NET PRESENT VALUE

$168,500 (difference between the present value of inflows and the initial investment)

BENEFIT COST RATIO = $568,500/$400,000 = 1.42PAYBACK PERIOD IS $400,000/$150,000 = 2.67 YEARSINTERNAL RATE OF RETURN IS 25.41%

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Net Present Value (NPV)

• The Net Present Value of an expenditure is determined by subtracting the sum of the discounted costs from the discounted benefits. In formula terms:

• Net Present Value = Sum of Discounted Benefits ‑ Sum of Discounted Costs

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Benefit/Cost Ratio

• The ratio between the sum of the discounted benefits and the sum of the discounted costs. If the Benefit/Cost ratio is greater than 1, then the project is viable from the financial point of view.

• This simple variation of Net Present Value assists in ranking a series of investment projects that are being reviewed.

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Payback or Payout

• The concept of payback or payout does not require using discounted cash flow information.

• We are less certain of predictions as they are made farther into the future. Therefore, an investment that generates sufficient cash benefits to pay for itself early in its life is less risky than one that takes longer to pay for itself.

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Internal Rate of Return

• The internal rate of return is the true rate of interest earned by the investment.

• A $400,000 investment that earns $150,000 per year for 5 years is yielding a 25.41% rate of return. When we compare this to the hurdle rate of 10% we are performing well.

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Comparing Alternatives

• All three of the discounted cash flow methods may be used to rank alternatives. However, the user of a financial evaluation must be aware of what the methods indicate.

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Comparing Alternatives

– Net present value is the conceptually superior method.

– The benefit cost ratio has the advantage of enabling comparison of projects of different sizes

– cash payback illustrates the amount of time that you are at risk.

– The internal rate of return lets you test the integrity of the discount rate.

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Critical value analysis

• Critical value analysis is a method of evaluation that is useful when the benefits or costs of a project are non-financial in nature

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Marginal value analysis

• As a final measure of the quality of benefits we should attempt to identify the marginal benefits that flow from marginal dollars. We might be able to attract 90% of the benefits by spending 50% of the dollars.

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Chapter Summary

• There are a wide variety of methods for evaluating expenditure alternatives. Some rely on monetary values and financial evaluation; some rely on qualitative analysis and intrinsic evaluation.

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Chapter Summary

• The analysis and evaluation of alternatives to an expenditure initiative must be:

• balanced/objective• realistic/attainable• easily understood• appropriate for the situation.

• We also discovered that financial evaluation can be fairly complicated. It is hoped that the spreadsheet provided as a supplement to this chapter, will make financial valuation much easier. (see appendix to chapter 8).

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Closing Remarks

• The next step is to make a choice. If our non-financial and financial evaluation has been accurate and relevant, making a choice will be easy. If our evaluation systems are flawed, making a choice may be impossible.

• Chapter 9 will deal with making choices and developing action plans so that choices are followed through.