The costs and benefits of a business case
Projects tie up a lot of resources in terms of time, costs and human resources, it is therefore important to assess these properly. Part of the assessment includes financial rewards derived from the projects.
The following project appraisal methods focus purely on the financial rewards of the project, however this should not be the only determining factor of whether management should select a project or not.
Indeed, focusing only on financial costs and benefits can lead to the following issues:
Non-financial costs or benefits might outweigh the financial ones
Managers might be encouraged to make use of ‘creative’ calculations of benefits and have them classified under financial benefits
Costs may be removed from forecasts in an attempt to ‘overstate’ the case for the project
Managers may include slack in forecasts in an attempt to show enough benefit to achieve project approval
Projects with no financial benefits will be automatically rejected
The payback period is how long it takes the cash inflows to exceed the initial outflow - "the time that it takes for an investment to pay for itself."
The quicker the better - particularly when the focus is on liquidity
Initial cost 3.6 million
Cash in annually 700,000
What is the payback period?
3,600,000 / 700,000 = 5.1429
Take the decimal (0.1429) and multiply it by 12 to get the months - in this case 1.7 months
So the answer is 5 years and 1.7 months
Consider the following data:
When the cumulative cashflow becomes positive then this is when the initial payment has been repaid and so is the payback period
So in the final year we need to make 10 more to recoup the initial 800. So, that’s 10 out of 120. 10/120 x 12 (number of months) = 1.
So the answer is 4 years 1 month.
Return on capital employed (ROCE)
Average annual profit (PBIT) of the investment / Cost of the investment
This is used when company’s are more interested in PROFITABILITY than liquidity
It uses profits rather than cashflows
The answer is expressed as a % and can be compared to a target return (often the company’s cost of capital)
Net Present Value
So, to appraise an investment we compare the cost to all the discounted inflows. The hopefully positive difference is the NPV
If a company has 2 projects under consideration it should choose the one with the highest NPV.
|Land & Buildings||2000|
|F & F||500|
20% of office overhead is an allocation of head office operating costs.
The cost of land and buildings includes a feasibility study which has already been paid of 100
The entity hope to sell the business at the end of year 4 for 1,500
Cost of capital is 10%
Tax is 30% and is payable one year after profits are earned
WDA on fittings and equipment at 25% on a reducing balance basis. None available on land and buildings.
Estimated resale proceeds of 100 for the fittings and equipment have been included in the total figure of 1,500 given above.
Working capital = 10% of next years sales
NPV = 7
Yr 1 500 x 25% x 30% = 37.5
Yr 2 37.5 x 75% = 28
Yr 3 28 x 75% = 21
Asset effective cost = (500 - 100) = 400.
So WDA should be 400 x 30% = 120, so extra 33.5
it considers the time value of money (that is in the discount rate used)
it gives an absolute figure not a percentage
it considers the whole life of the project
is based on real cashflows.
is the reliance placed on the cost of capital - this can be tricky to calculate (as we shall see later)
inflation rates for selling price and variable cost are assumed to be constant in future periods. In reality, interaction between a range of economic and other forces influencing selling price per unit and variable cost per unit will lead to unanticipated changes in both of these project variables
it is heavily dependent on the production and sales volumes forecasts
Internal Rate of Return
The IRR is essentially the discount rate where the initial cash out (the investment) is equal to the PV of the cash in. So, it is the discount rate where the NPV = 0
Consequently, to work out the IRR we need to do trial and error NPV calculations, using different discount rates, to try and find the discount rate where the NPV = 0.
The good news is you only need to do 2 NPV calculations and then apply a formula.
That formula is:
L + NPV L / [NPV L - NPV H x (H - L)]
L= Lower discount rate
H = Higher discount rate
NPV L = NPV @ lower rate
NPV H = NPV @ higher rate
If a project had an NPV of 50,000 when discounted at 10%, and -10,000 when discounted at 15% - what is the IRR?
10 + (50,000/60,000) x 5% = 14.17%
ROCE, Payback, NPV and IRR compared
|Time value of money accounted for?||Yes||Yes||No||No|
|Use relevant cashflows?||Yes||Yes||No||No|
|Looks at cashflows for all investment’s life?||Yes||Yes||Yes||No|