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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 different resources, different locations, different technology, different schedules or even doing nothing...

Does this project represent the best possible

value for money?

In receivership after less than a year!

How many thousand cars per day?

135
100 110

59 27

60

Average

No toll

Opening

2012 Forecast

2014

2026

Actual

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 particular project and calculate the value of that money in todays terms.

NPV =

t=0

FVt (1 + i)t

Discounting
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.
N

NPV =

t=0

FVt (1 + i)t

Lunch and Learn Economic Valuation of Projects

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 =

t=0

FVt (1 + i)t

Lunch and Learn Economic Valuation of Projects

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)

Calculating NPV
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 10%

- $1,000
-$ -$ $ $ $ $ $ $ 909 83 150 342 497 339 205 541

-$100

$200

$500

$800

$600

$400

Value in todays terms (discounted at 10%)

NPV =

t=0

FVt (1 + i)t

Lunch and Learn Economic Valuation of Projects

Calculating IRR
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

22.93%

- $1,000
-$ 813 -$ 66 $ 108 $ 219 $ 285 $ 174 $ 94 $ 0

-$100

$200

$500

$800

$600

$400

IRR is the rate at which the NPV = zero

NPV =

t=0

FVt (1 + i)t

=0

Lunch and Learn Economic Valuation of Projects

Simple example

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 this uncertainty. 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?

Money has a shelf life

Time is money
Benjamin Franklin

It is much better to have $1,000 today than tomorrow.

Why is this important? It is much better to have positive cash flows earlier in a project (and to try and delay cash outflows)
Lunch and Learn Economic Valuation of Projects

Dont forget about tax

This is too difficult for a mathematician. It should be asked of a philosopher.

Albert Einstein (filling out his tax return)

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.

Lunch and Learn Economic Valuation of Projects

Beware the butterfly effect

Change one thing, change everything.

Tagline for the movie 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.

Lunch and Learn Economic Valuation of Projects

Change control is your friend

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

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.
Lunch and Learn Economic Valuation of Projects

Excel does not always equal Excellent

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

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.

Lunch and Learn Economic Valuation of Projects

The model is one chapter in the story

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

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.
Lunch and Learn Economic Valuation of Projects