Business Case Development

Core Professional Skills Training Document Fall, 2011

Agenda
Outline of Todays Business Case Training Session:
Introduction to Business Case Development Financial Justification
Terms and Metrics
Pre-Tax Cash Flow Payback Period Accounting Terms and Principles Depreciation Methods After-Tax Cash Flow Discounted Cash Flow Net Present Value Internal Rate of Return Modified Internal Rate or Return Economic Value Added

Packaging a Business Case

Introduction to Business Case Development

What is the Purpose of a Business Case?

The purpose of a business case approach is to present a persuasive argument for a recommended path forward.

The 3 Legs of a Persuasive Argument

Logic Credibility Appeal

What is a Business Case?

In its simplest form, a business case is about justifying the investment required by the potential value created.

Business = Case

Value Created Investment Required

Types of Investment?
An investment can be considered as any type of commitment necessary to create value, most of which can be translated to monetary terms. Example investments:
Capital and Assets
Systems Equipment Building Inventory People Supplies Professional Fees Travel Expenses

Impact the Balance Sheet

Expenses

Impact the Income Statement

What is Value?
There are many ways to create value, all of which can be articulated in a business case.

Value =

Revenue Growth Quality Service Flexibility Risks Time Costs Working Capital Taxes

Increase These

Decrease These
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Financial Justification

Financial Justification
Ideally, financial justification provides the meaningful monetary statistics necessary to drive a decision.

Financial Justification Ten Basic Steps

Below are a few suggested basics steps to follow when developing a detailed business case.
Basic Steps to Financial Justification
1. Specify the feasible alternatives 2. Determine the financial metrics to assess 3. Establish pre-tax cash flow estimates

Considerations
What are we comparing against? What is the cost of doing nothing? What financial metrics will be compared (e.g. NPV, IRR, MIRR, EVA, etc.)? What are the positive and negative cash flows for each alternative What is the timing of these cash flows? What is the cash flow horizon? How do we impact the income statement? How do we impact the balance sheet? What will be capitalized vs. expensed? What depreciation method will be used? What is the depreciation time period for each asset? What is the client income tax rate? What rate will be used to determine the NPV of cash flows? How do the numbers stack up and compare? Does the answer change is different assumptions are used? What other factors need to be considered beyond the ROI? What is the level of detail needed to present your recommendation? What questions must be answered to drive a decision? 10

4. Use accounting view of cash flow and ROI (return on investment) 5. Determine depreciation expense

6. Calculate after-tax cash flow 7. Calculate discounted cash flow 8. Assess alternatives based on financial metrics 9. Perform qualitative analysis 10. Package the business case

1. Define the Feasible Alternatives

The first step in justifying an investment is to define the feasible alternatives, including the possibility of doing nothing. What are the alternatives?
Are we offering just one alternative? What is the cost of doing nothing?

The do nothing alternative:

The easiest alternative to do, but not always a practical There is usually a cost of doing nothing Compare the cost of doing nothing vs. feasible alternatives Often, an alternative with a relatively low return can be justified when compared with doing nothing

Comparing the recommended investment with multiple alternatives, including doing nothing, provides a perspective to aid in the decision making process
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2. Determine the Financial Metrics to Assess

The term Return on Investment (ROI) is often used synonymously with a business case, but there are many terms and metrics to consider.
Net Cash Flow: Sum of negative and positive cash flows Simple ROI: Ratio of net cash flow divided by the initial investment Discount Rate: The interest rate (or opportunity cost of capital rate) used in determining the present value of future cash flows. The opportunity cost of capital can either be how much you would have earned investing the money someplace else, or how much interest you would have had to pay if you borrowed money Discounted Cash Flow (DCF): Common method of estimating an investment's present value based on the discounting of projected cash inflows and outflows Simple Payback: The period of time, usually measured in years, required to recover the original project investment and not applying a discount rate Discounted Payback: the period of time, usually measured in years, required to recover the original project investment considering the time value of money NPV: The net present value of expected future cash flows of a project minus the initial project investment IRR: The internal return rate which equates the present value of a projects expected cash inflows to the present value on its expected outflows can also be viewed as the expected rate of return on a project Modified IRR (MIRR): The internal rate of return using a reinvestment rate for positive cash flows equivalent to the companys cost of capital or average rates of return Economic Value Added (EVA): EVA equals Net Operating Profit After Taxes (NOPAT) less the opportunity cost of capital.
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Financial Metric Considerations

Net Cash Flow Simple ROI Simple Payback
Simple, but does not consider time value of money Overstates the relative value of longer term cash flow Simple, but does not consider time value of money Difficult to compare alternative investments without also knowing size of cash flow Conceptually easy to understand Measures relative risk of projects (i.e. short payback = lower risk) Simple, but does not consider time value of money Does not consider positive cash flow after breakeven Generally difficult to determine what rate to use Perform sensitivity analysis using discount rates More acceptable version of payback But, does not consider positive cash flow after breakeven Most acceptable method of evaluating cash flows Perform sensitivity analysis of different discount rates and time horizons Result of discount cash flow analysis Positive NPV represents a favorable project Pursue the project alternative with the highest NPV Often compared against desired hurdle rates, which are generally higher than the cost of capital Pursue project alternative that exceed internal hurdle rate Incorrectly assumes positive cash flow can be reinvested at IRR Assumes positive cash flows are reinvested at avg. company rate of return Generates more conservative and realistic expected rate of return Evaluates project return against the cost of capital investment Generally, more difficult to calculate correctly without Accountant oversight 13

Discount Rate Discounted Payback Discounted Cash Flow (DCF) Net Present Value (NPV) Internal Rate of Return (IRR)

Modified IRR (MIRR) Economic Value Added (EVA)

3. Establish Pre-Tax Cash Flow Estimates

The core component of a financial justification is the anticipated positive and negatives cash flow associated with the investment. What are the value levers impacted by the investment? Examples:
Costs Revenue Working Capital

What is the incremental cash flow for each value lever? When will these savings begin? What are the costs associated with the investment
One time Ongoing

Pre-tax cash flow analysis allows for quick and dirty calculations such as Simple ROI and Simple Payback.
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Net Cash Flow - Project A

Net Cash Flow is the cumulative sum of negative and positive cash flows over the life span of the investment.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows Net Cash Flow 0 $0 1 $0 2 $150 $0 3 $150 $0 $150 4 $150 $0 $150 5 $150 $0 $150 Total $600 ($300) $300

($200) ($100)

($200) ($100) $150

The net cash flow is a positive $300.

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Net Cash Flow - Project B

Net Cash Flow is the cumulative sum of negative and positive cash flows over the life span of the investment.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows Net Cash Flow 0 $0 1 $0 2 $250 $0 3 $250 $0 $250 4 $250 $0 $250 5 $250 $0 $250 6 $250 $0 $250 7 Total

$250 $1,500 $0 ($500)

($400) ($100)

($400) ($100) $250

$250 $1,000

The net cash flow is a positive $1,000.

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Net Cash Flow and Simple ROI - Project A

One way to evaluate the net cash flow is through a Simple ROI calculation. Simple ROI is the ratio of net cash flow divided by the initial investment.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows Net Cash Flow Net Cash Flow Total Investment Simple ROI 0 $0 1 $0 2 $150 $0 3 $150 $0 $150 4 $150 $0 $150 5 $150 $0 $150 Total $600 ($300) $300

($200) ($100)

($200) ($100) $150 $300 ($300) 100%

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Net Cash Flow and Simple ROI - Project B

One way to evaluate the net cash flow is through a Simple ROI calculation. Simple ROI is the ratio of net cash flow divided by the initial investment.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows Net Cash Flow Net Cash Flow Total Investment Simple ROI 0 $0 1 $0 2 $250 $0 3 $250 $0 $250 4 $250 $0 $250 5 $250 $0 $250 6 $250 $0 $250 7 Total

$250 $1,500 $0 ($500)

($400) ($100)

($400) ($100) $250 $1,000 ($500) 200%

$250 $1,000

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Simple Payback - Project A

Simple Payback is perhaps the most popular quick and dirty method of evaluating a potential investment. Simply payback is the period of time, usually measured in years, required to recover the original project investment.
Financial Analysis Investment Life Span (Years) Cumulative Cash Flow Payback Years 0 ($200) 3 1 ($300) 2 ($150) 3 $0 4 $150 5 $300 Total $600

Cumulative Cash Flow & Payback

0
$400 $300 $200 $100 $0 ($100) ($200) ($300) ($400)

3.0

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Simple Payback - Project B

Simple Payback is perhaps the most popular quick and dirty method of evaluating a potential investment. Simply payback is the period of time, usually measured in years, required to recover the original project investment.
Financial Analysis Investment Life Span (Years) Cumulative Cash Flow Payback Years 0 1 2 3 $0 4 $250 5 $500 6 7 Total

($400) ($500) ($250) 3

$750 $1,000 $1,000

Cumulative Cash Flow & Payback

0 1 2 3 4 5 6 7
$1,200 $1,000 $800 $600 $400 $200 $0 ($200) ($400) ($600)

Using payback period as the criteria, project A and B are equal.

3.0

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Time Horizon Considerations - Example 1

Generally, the longer the cash flow horizon the higher the return. Example of 5 vs. 7 Year Horizon:
Cumulative Discounted Cash Flow
(5 Year Horizon)
$600 $400 $200 $0 0 ($200) ($400) 1 2 3 4 5

NPV = $141

Cumulative Discounted Cash Flow

(7 Year Horizon)
$600 $400 $200 $0 0 ($200) ($400) 1 2 3 4 5 6 7

NPV = $303

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Time Horizon Considerations - Example 2

The time horizon assumed for the ROI analysis can have a significant impact on whether an investment is deemed favorable or not.
Anticipated Cash Flow 3 Year Horizon
$1.0 M annual savings 0 1 2 3 $2.0 M Initial Investment
(Discount Rate = 10%)

Net Cash Simple Flow ROI

Payback

NPV

IRR

MIRR

$1.0 M

50%

$0.49 M

23%

18%

6 Year Horizon

$1.0 M annual savings 0 1 2 3 4 5 6 $2.0 M Initial Investment

(Discount Rate = 10%)

$4.0 M

200%

$2.36 M

45%

25%

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Time Horizon Considerations - Example 3

The time horizon assumed for the ROI analysis can have a significant impact on whether an investment is deemed favorable or not.
Anticipated Cash Flow 3 Year Horizon
0 1 2 3 $2.0M annually savings

Net Cash Simple Payback Flow ROI

NPV

IRR

MIRR

$1.0 M
$5.0 M initial investment
(Discount Rate = 10%)

20%

2.5

($0.03) M

10%

10%

6 Year Horizon
0

$2.0 M annually savings

$7.0 M
1 2 3 4 5 6 $5.0 M initial investment
(Discount Rate = 10%)

140%

2.5

$3.71 M

33%

21%

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Net Cash Flow - Words of Wisdom

Set practical expectations on cash flow estimates.

OVERAMBITIOUS
Your Ambition Is Noteworthy But Not Very Practical
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4. Use Accounting View of Cash Flow & ROI

A cash flow and ROI analysis must be put into accounting terms.
Increase Revenues

Costs & Revenues

Decrease COGS Reduce Selling Costs Reduce Distribution Costs Reduce Admin. Costs

Increase Gross Profit

Reduce Income Taxes Increase Net Operating Profit Before Taxes Increase Net Income

Reduce Operating Expenses

Reduce Interest Expense

Increase Return on Investment

Assets & Liabilities

Depreciation Reduce Working Capital Reduce Fixed Assets Reduce Net Capital Reduce % Cost of Capital

Reduce Capital Charges

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Income Statement - Example

The income statement represents the overall revenue, costs, and profit of the organization.
Income Statement (000s) Revenue Cost of Good Sold (COGS) Gross Income $2,000 ($1,000) $1,000 50% ($400) Selling, general, and administrative costs $600 Earnings before interest, taxes, depreciation and amortization ($200) Non Cash Expense (*often embedded in SG&A) $400 20% ($20) $40 $420 Earnings before interest and taxes ($50) $370 ($148) $222 Note that Net Income is not equivalent to Net After Tax Cash Flow 11% 26

Gross Margin
Operating Expenses (SG&A)*

EBITDA
*Depreciation Operating Income

Operating Margin
Other Non-Operating Expenses Other Non Operating Revenue

EBIT
Interest Expense Net Profit Before Taxes Taxes Net Income

Profit Margin

Balance Sheet - Example

A balance sheet states a companys assets, liabilities (debt) and equity (net worth), where Assets = Liabilities + Equity. Example:
Assets (000s) Cash $ Securities $ Accounts Receivable $ Inventory $ Prepaid Expenses $ Other Current Assets $ Total Current Assets $ Long Term Investments $ Property, Plant & Equipment $ Intangible Assets $ Other Assets $ Total Assets $ Liabilities Short Term Debt Accounts Payable Accrued Expenses Other Payables Current Portion of Long Term Debt Total Current Liabilities Long Term Debt 42 28 166 490 16 33 775 87 760 100 1,722

Less Accumulated Appreciation

$ $ $ $ $ $

50 198 10 63 321 500 821

$ Total Liabilities $

Equity Capital Stock Additional Paid in Capital Retained Earnings

$ $ $ Total Equity $

700 37 164 901 1,722

What balance sheet line items do we typically impact?

Total Debt & Equity $

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Financial Ratios
Common financial ratios used in evaluating the financial health of an organization.
2.4 0.9 0.2 $454.0 Liquidity - Ability to meet short term obligations Current Ratio = Current Assets/Current Liabilities Quick (Acid Test) Ratio = (Current Assets - Inventory)/Current Liabilities Cash Ratio = (Cash + Marketable Securities)/Current Liabilities Working Capital = Current Assets Current Liabilities Activity - Ability to effectively utilize assets Days of Cash = Cash/(Sales/365) Average Collection Period (in days) = Accounts Receivable/(Sales/365) Days of Inventory = Inventory/(COGS/365) Receivables Turnover = Sales/Receivables Inventory Turns = COGS/Inventory Asset Turnover = Sales/Total Assets Profitability - Ability to generate profit Net Profit Margin = Net Income/Sales Gross Profit Margin = (Sales - COGS)/Sales Operating Profit Margin = (Sales - COGS - SGA)/Sales Return on Assets = Net Income/Total Assets = Net Profit Margin x Asset Turnover Return on Equity = Net Income/Total Equity

7.7 30.3 178.9 12.0 2.0 1.2

11.1% 50.0% 20.0% 12.9% 30.1%

Leverage - Ability to protect creditor investment 0.5 Debt to Asset Ratio = Total Liabilities/Total Assets 1.1 Debt to Equity Ratio = Total Liabilities/Total Equity 8.8 Times Interest Earned = Net Income Before Taxes and Interest/Interest Expense 28

After Tax Cash Flow - Example

A ROI analysis must be based on net cash flow after taxes. Depreciation is a non-cash expense but used to determine the cash flow of income taxes.
Net Cash Flow (example) Revenue $2,040 - COGS ($1,000) - Expenses (excl. depreciation) ($470) - Depreciation ($200) Net Profit Before Taxes $370 - Taxes ($148) Net Profit After Taxes $222 + Depreciation (add back) $200 = Net After-Tax Cash Flow $422

Depreciation expense reduces tax liability Generally, it is included as part of operating expenses However, it is a non-cash based expense Therefore, depreciation is added back to net profit after taxes
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5. Determine Depreciation Expense

General considerations when determining depreciation:
Tangible operational assets, except land, are subject to depreciation because they have limited economic lives. Depreciation begins the period when the asset is placed into service for its intended use Depreciation is a non-cash expense that reduces the assets book value and a companys tax liability Depreciation for each asset is usually calculated separately and is based on four factors:
Acquisition cost; Estimated life; Residual (or salvage) value (book value after being fully depreciated); Method of depreciation selected.

Acquisition costs is all cost incurred to acquire, transport and prepare the asset for its intended use, such as sales tax, commissions, transportation, and installation. Estimated life is the number of years a company expects the asset to last or the amount of measurable production it expects from asset. Residual value is an estimate of the dollar amount that can be recovered for the asset at the end of its useful life when it is disposed of (sold or traded in). This remaining amount cannot be depreciated for financial reporting purposes. Acquisition cost Residual Value = Depreciable Base Several potential depreciation methods may be used (to be further discussed)

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Depreciation of Capital Expenditures

Capital expenditures (CAPEX) form the basis of the assets being depreciated.
Capital expenditures (CAPEX) are expenditures creating future benefits. CAPEX is incurred when a business spends money either to buy fixed assets or improve the value of an existing fixed asset with a useful life that extends beyond the taxable year. The general rule is that if the property acquired has a useful life longer than the taxable year, the cost must be capitalized. The CAPEX costs are then amortized or depreciated over the life of the asset. For accounting purposes, a CAPEX is added to an asset account (e.g. Property, Plant, and Equipment), and the assets book value is decreased annually by the amount of accumulated depreciation. For tax purposes, CAPEX are costs that cannot be deducted in the year in which they are paid or incurred, and must be capitalized. If the expense is one that simply maintains the asset at its current condition, the cost must be deducted fully in the year of the expense.
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Depreciation Acquisition Cost

The capital amount is the acquisition cost, which is all cost incurred to acquire, transport and prepare the asset for its intended use, such as sales tax, commissions, transportation, and installation.
Example: Invoice price, gross $ Less: 20% discount State sales tax @ 5% Transportation costs Installation costs $ $ $ $ Invoice price, net $ 150,000 (30,000) 120,000 6,000 4,000 10,000 140,000

Total Acquisition Cost $

Consideration for Consulting Fees: Typically, they are:

Included if they are engaged in detail design, development, and installation of the asset Excluded if they are engaged in process design, selection, training, and operations transition
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Depreciation - Methods
There are several methods for depreciating assets. And, a company may choose a different method for financial reporting vs. tax reporting.
Financial Reporting Methods Generally Accepted Accounting Principles (GAAP) is the standard framework of guidelines for financial reporting GAAP Methods for Depreciation
Straight Line Productive Output Declining Balance Sum of the Years Digits

The depreciation period is based on its estimated useful file or units

Tax Reporting Methods Modified Accelerated Cost Recovery System (MACRS) is the current method of accelerated asset depreciation required by the United States income tax code. Specific types of assets are assigned to X-year property classes with distinct accelerated depreciation schedules. MACRS is required by the IRS for tax reporting but is not approved by GAAP for external reporting.

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Depreciation Straight Line Depreciation

Straight line depreciation is the easiest to determine.
Depreciation = (Cost - Salvage value) / Useful life Example:
Acquisition Cost Salvage Value Depreciable Value Useful Life Depreciation/Year $140,000 $20,000 $120,000 5 Years $120,000/5 = $24,000

The MS Excel Function is SLN(cost,salvage,life), where

Cost is the initial cost of the asset. Salvage is the value at the end of the depreciation (sometimes called the residual value of the asset). Life is the number of periods over which the asset is depreciated (sometimes called the useful life of the asset).
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Depreciation Straight Line Depreciation

Example of Straight Line Depreciation:
Example:
Acquisition Cost Salvage Value Depreciable Value Useful Life
Year Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value $ $ -

$140,000 $20,000 $120,000 5 Years

0 1 20% 2 20% 3 20% 4 20% 5 20%

$120,000 $120,000 $120,000 $120,000 $120,000 $120,000 $ 24,000 $ 24,000 $ 24,000 $ 24,000 $ 24,000 $ 24,000 $ 48,000 $ 72,000 $ 96,000 $120,000

$140,000 $140,000 $116,000 $ 92,000 $ 68,000 $ 44,000 $140,000 $116,000 $ 92,000 $ 68,000 $ 44,000 $ 20,000

*Example assumes asset is placed into service at end of year 0.

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Depreciation Straight Line vs. Accelerated

Accelerated depreciation methods are commonly used because they reduce a companys tax burden during the initial years following installation more so than the straight line method. Example:
Cost = $140,000, Salvage Value = $20,000, and Useful Life = 5 Years
Useful Life (Years) 0 1 Cash Inflow $0 $80,000 Cash Outflows ($140,000) $0 Net Cash Flow ($140,000) $80,000 (Pre-Tax) Straight Line Depreciation Depreciation $0 ($24,000) (Straight Line) Net Operating Profit $0 $56,000 (Before Tax) Taxes $0 ($22,400) (40%) Accelerated Depreciation (Sum of Years Digits) Depreciation $0 ($40,000) (Accelerated) Net Operating Profit $0 $40,000 (Before Tax) Taxes $0 ($16,000) (40%) *Example assumes asset is placed into service at end of year 0. Financial Analysis 2 3 $80,000 $80,000 $0 $0 $80,000 $80,000 4 $80,000 $0 $80,000 5 $80,000 $0 $80,000 Total $400,000 ($140,000) $260,000

($24,000) $56,000 ($22,400)

($24,000) $56,000 ($22,400)

($24,000) $56,000 ($22,400)

($24,000) $56,000

($120,000) $140,000

($22,400) ($112,000)

($32,000) $48,000 ($19,200)

($24,000) $56,000 ($22,400)

($16,000) $64,000 ($25,600)

($8,000) $72,000

($120,000) $140,000

($28,800) ($112,000)

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Depreciation Sum of the Years Digits

Sum of the years digits is an accelerated depreciation method with a decreasing percentage of depreciation applied each year.
Depreciation = [Useful Life (Current Period 1)]/SYD * Depreciable Value, Where SYD = Useful Life*[(Useful Life+1)/2] Example
Acquisition Cost Salvage Value Depreciable Value Useful Life Current Period $140,000 $20,000 $120,000 5 Years 3rd Year

SYD = 5*[(5+1)/2] = 15, or 1+2+3+4+5 = 15 Depreciation = [5-(3-1)]/15*$120,000 = $24,000

The MS Excel Function is SYD(cost,salvage,life,per), where Per is the period being depreciated
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Depreciation Sum of the Years Digits

Example of Sum of the Years Depreciation:
Example
Acquisition Cost Salvage Value Depreciable Value Useful Life
Year Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value $ $ -

$140,000 $20,000 $120,000 5 Years

0 1 33% 2 27% 3 20% 4 13% 5 7%

$120,000 $120,000 $120,000 $120,000 $120,000 $120,000 $ 40,000 $ 32,000 $ 40,000 $ 72,000 $ 24,000 $ 16,000 $ 8,000 $ 96,000 $112,000 $120,000 $ 44,000 $ 28,000 $ 20,000

$140,000 $140,000 $100,000 $ 68,000 $ 44,000 $ 28,000 $140,000 $100,000 $ 68,000

*Example assumes asset is placed into service at end of year 0.

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Depreciation Fixed Declining Balance

Fixed declining ball is an accelerated depreciation method where a fixed percentage of the remaining book value is depreciated during each year of the useful life of the asset. This method is not recommended.
Depreciation =[1-((Salvage Value/Cost)^(1/Life))]*Book Value,
Where Book Value = Acquisition Cost Accumulated Depreciation

The MS Excel Function is DB(cost,salvage,life,period,month) where month is the number of months in the first year. If month is omitted, it is assumed to be 12. Unfortunately, the formula and the MS Excel function causes initial depreciation calculations to be extreme any time the salvage value is less than approximately 10% of the asset's acquisition cost, and any asset with a zerodollar salvage value will be fully depreciated in the first period.

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Depreciation Fixed Declining Balance

Example of Fixed Declining Balance Depreciation. This method is not recommended.
Example:
Acquisition Cost Salvage Value Useful Life $140,000 (equals initial book value) $20,000 (must be >=10% of cost) 5 Years

Year Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value $ $

1 32% -

2 32%

3 32%

4 32%

5 32%

$140,000 $140,000 $ 94,920 $ 64,356 $ 43,633 $ 29,583 $ 45,080 $ 30,564 $ 20,723 $ 14,050 $ 9,583 $ 45,080 $ 75,644 $ 96,367 $110,417 $120,000

$140,000 $140,000 $ 94,920 $ 64,356 $ 43,633 $ 29,583 $140,000 $ 94,920 $ 64,356 $ 43,633 $ 29,583 $ 20,000

*Example assumes asset is placed into service at end of year 0.

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Depreciation Double Declining Balance

Double declining ball is a common method of accelerated depreciation, where the straight line percentage is doubled and applied to the remaining book value of the asset.
Depreciation =(1/Life*2)*Book Value, Where Book Value = Acquisition Cost Accumulated Depreciation Example:
Acquisition Cost Salvage Value Useful Life Current Period Factor 1st Year 2nd Year 3nd Year $140,000 (equals initial book value) $20,000 5 Years 3rd Year = = = = (1/5*2) = 40% 40% * $140,000 = $56,000 40% * ($140,000 - $56,000) = $33,600 40% * ($140,000 - $89,600) = $20,160

Depreciation Depreciation Depreciation Depreciation

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Depreciation Double Declining Balance

The MS Excel VDB function rather than the DDB function should be used to calculate double declining depreciation.
The MS Excel Function is DDB(cost,salvage,life,period,factor), where factor is the rate at which the balance declines. If factor is omitted, it is assumed to be 2 (the doubledeclining balance method). Unfortunately, the MS Excel function does not fully depreciate the entire balance if the salvage value of the asset is low compared to its acquisition cost. The switch to the straight-line method is necessary in the year that the straight-line method, using the remaining depreciable balance, yields a higher depreciation expense than the double-declining method. Fortunately, the MS Excel VDB function will correctly calculate the depreciation for each year VDB(cost,salvage,life,start_period,end_period,factor,no_switch), where:
Start_period is the starting period for which you want to calculate the depreciation. End_period is the ending period for which you want to calculate the depreciation. Factor is the rate at which the balance declines. If factor is omitted, it is assumed to be 2 (the double-declining balance method). No_switch is a logical value specifying whether to switch to straight-line depreciation when depreciation is greater than the declining balance calculation. If no_switch is FALSE or omitted, Excel switches to straight-line depreciation when depreciation is greater than the declining balance calculation. 42

Depreciation Double Declining Balance

Example of Double Declining Balance Depreciation:
Example:
Acquisition Cost Salvage Value Useful Life $140,000 (equals initial book value) $20,000 5 Years

VDB(cost,salvage,life,start_period,end_period,2,False),
Year 0 1 40% $ $ $ 56,000 $ 56,000 2 40% 3 40% 4 34% $ 30,240 $ 10,240 $ 5 0% $ 20,000 -

Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value

$140,000 $140,000 $ 84,000 $ 50,400 $ 33,600 $ 20,160

$ 89,600 $109,760 $120,000 $120,000 $ 30,240 $ 20,000 $ 20,000 $ 20,000

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$140,000 $140,000 $ 84,000 $ 50,400 $140,000 $ 84,000 $ 50,400 $ 30,240

*Example assumes asset is placed into service at end of year 0.

Depreciation 150% Declining Balance

Variations of declining balance may be used. The following is an example of 150% Declining Balance Depreciation:
VDB(cost,salvage,life,start_period,end_period,1.5,False), Example:
Acquisition Cost Salvage Value Useful Life $140,000 (equals initial book value) $20,000 5 Years

Year Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value $ $

1 30% -

2 30%

3 30%

4 30%

5 41%

$140,000 $140,000 $ 98,000 $ 68,600 $ 48,020 $ 33,614 $ 42,000 $ 29,400 $ 20,580 $ 14,406 $ 13,614 $ 42,000 $ 71,400 $ 91,980 $106,386 $120,000

$140,000 $140,000 $ 98,000 $ 68,600 $ 48,020 $ 33,614 $140,000 $ 98,000 $ 68,600 $ 48,020 $ 33,614 $ 20,000
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*Example assumes asset is placed into service at end of year 0.

Depreciation Productive Output

Productive output is a variable of method of depreciation where the useful life of the asset is based on the expected number of lifetime units to be produced, hours to be consumed, etc.
Depreciation = (Cost - Salvage value) * (Actual Units Produced/Lifetime Units Expected) Example:
Acquisition Cost Salvage Value Depreciable Value Lifetime Units Depreciable $/Unit Year Productive Output Depreciation Percentage Depreciation Expense $140,000 $20,000 $120,000 100,000 $1.20 1 15,000 15% 2 25,000 25% 3 25,000 25% 4 20,000 20% 5 15,000 15%

$ 18,000 $ 30,000 $ 30,000 $ 24,000 $ 18,000

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Depreciation Productive Output

Example of Productive Output Depreciation:
Example:
Acquisition Cost Salvage Value Depreciable Value Lifetime Units Depreciable $/Unit
Year Productive Output Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value $ $ -

$140,000 $20,000 $120,000 100,000 $1.20

0 1 15,000 15% 2 25,000 25% 3 25,000 25% 4 20,000 20% 5 15,000 15%

$120,000 $120,000 $120,000 $120,000 $120,000 $120,000 $ 18,000 $ 30,000 $ 30,000 $ 24,000 $ 18,000 $ 18,000 $ 48,000 $ 78,000 $102,000 $120,000

$140,000 $140,000 $122,000 $ 92,000 $ 62,000 $ 38,000 $140,000 $122,000 $ 92,000 $ 62,000 $ 38,000 $ 20,000
46

*Example assumes asset is placed into service at end of year 0.

Depreciation Methods Comparison

The straight line method is the easiest to compute whereas accelerated methods accelerate the tax benefit by expensing depreciation earlier over an assets useful life.

Illustration
Depreciation Expense Comparison
$60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $1 2 3 Years
47

Straight Line Sum of the Years Digits Fixed Declining Balance 150% Declining Balance Double Declining Balance Productive Output

Depreciation - MACRS
Modified Accelerated Cost Recovery System (MACRS) is the current method of accelerated asset depreciation required by the United States income tax code.
Assets are grouped into property classes The depreciation is predetermined by the MACRS table for each property class The two most common asset classes besides real estate are the five-year and the sevenyear asset class.
The five-year asset class includes information systems, computers, and vehicles The seven-year class includes most machinery and equipment

Residual value is ignored All fixed assets are assumed to be put in and taken out of service in the middle of the year. Therefore:
For the five-year class assets, depreciation is spread over six years. For seven-year class assets, depreciation is spread over eight years. The useful life is 39 years for nonresidential real property. Depreciation is straight line using the midmonth convention.

It is arguable as to whether a company may use the MACRS method for both financial statement and tax purposes MACRS can be more beneficial to the company because it reduces initial tax liability. However, it also reduces initial net income, which is another reason why businesses may choose to use less aggressive methods for depreciation on their financial reports.
48

Depreciation MACRS Table

The table below represents the required depreciation for taxes purposes based on asset property class.*
% by Year by Property Class

A half-year depreciation is allowed in the first and last recovery years. Depreciation rates:
The 3, 5, 7, and 10-year classes begin with double declining balance depreciation 15- and 20-year classes begin with 150% declining balance depreciation. All classes convert to straight-line depreciation in the year highlighted

*If more than 40% of the year's MACRS property is placed in service in the last three months, then a mid-quarter convention (separate table).

Recovery Year 3 5 7 10 15 1 33.33% 20.00% 14.29% 10.00% 5.00% 2 44.45% 32.00% 24.49% 18.00% 9.50% 3 14.81% 19.20% 17.49% 14.40% 8.55% 4 7.41% 11.52% 12.49% 11.52% 7.70% 5 11.52% 8.93% 9.22% 6.93% 6 5.76% 8.92% 7.37% 6.23% 7 8.93% 6.55% 5.90% 8 4.46% 6.55% 5.90% 9 6.56% 5.91% 10 6.55% 5.90% 11 3.28% 5.91% 12 5.90% 13 5.91% 14 5.90% 15 5.91% 16 2.95% 17 18 19 20 21

20 3.75% 7.22% 6.68% 6.18% 5.71% 5.29% 4.89% 4.52% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 2.23% 49

Depreciation - MACRS
Example of MACRS Depreciation:
Example:
Acquisition Cost Salvage Value Property Class $140,000 (equals initial book value) $20,000 (not used in MACRS calculation) 5 Years

Year Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value

1 20.00%

2 32.00%

3 19.20%

4 11.52%

5 11.52%

6 5.76%

$140,000 $140,000 $140,000 $140,000 $140,000 $140,000 $ 28,000 $ 44,800 $ 26,880 $ 16,128 $ 16,128 $ 8,064 $ 28,000 $ 72,800 $ 99,680 $115,808 $131,936 $140,000 $140,000 $112,000 $ 67,200 $ 40,320 $ 24,192 $ 8,064 $112,000 $ 67,200 $ 40,320 $ 24,192 $ 8,064 $
*Example assumes asset is placed into service at any point in year 1.

50

6. Calculate After Tax Cash Flow

Basic steps to determine after tax cash flow:

First, estimate pre-tax cash flows for each year of the investment life span
Outflow (e.g. one time capital and expenses) Inflow (e.g. net annual savings)

Determine the annual depreciation on the capital investment Subtract the annual depreciation from the pre-tax cash flow to determine the taxable net income (Net Operating Profit before Taxes) Calculate the tax expense (for non-capital spending). The result is the Net Operating Profit after Taxes (NOPAT) Subtract the tax expense from the pre-tax cash flows to arrive at the after tax cash flow.

51

Net Cash Flow After Taxes - Project A

Investments must be evaluated on an after tax basis.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows (Assumes Capital in Y0; Expense Y1) Net Cash Flow (Pre-Tax) Depreciation (5 Years) Net Operating Profit (Before Tax) Taxes (40%) Net Cash Flow (After Tax) Net Cash After Tax Flow Total Investment Simple ROI (After-Tax Cash Flow) 0 $0 ($200) ($200) $0 $0 $0 ($200) $180 ($300) 60% 1 $0 ($100) ($100) ($40) ($140) $56 ($44) 2 $150 $0 $150 ($40) $110 ($44) $106 3 $150 $0 $150 ($40) $110 ($44) $106 4 $150 $0 $150 ($40) $110 ($44) $106 5 $150 $0 $150 ($40) $110 ($44) $106 Total $600 ($300) $300 ($200) $100 ($120) $180

*Depreciation is a non-cash expense. Calculation assumes $200 is a capitalized investment depreciated over 5 years on a straight line basis and with no salvage value.

52

Net Cash Flow After Taxes - Project B

Investments must be evaluated on an after tax basis.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows (Assumes Capital in Y0; Expense Y1) Net Cash Flow (Pre-Tax) Depreciation (5 Years) Net Operating Profit (Before Tax) Taxes (40%) Net Cash Flow (After Tax) Net Cash After Tax Flow Total Investment Simple ROI (After-Tax Cash Flow) 0 $0 ($400) ($400) $0 $0 $0 ($400) $600 ($500) 120% 1 $0 ($100) ($100) ($80) ($180) $72 ($28) 2 $250 $0 $250 ($80) $170 ($68) $182 3 $250 $0 $250 ($80) $170 ($68) $182 4 $250 $0 $250 ($80) $170 ($68) $182 5 $250 $0 $250 ($80) $170 ($68) $182 6 $250 $0 $250 $0 $250 ($100) $150 7 $250 $0 $250 $0 $250 ($100) $150 Total $1,500 ($500) $1,000 ($400) $600 ($400) $600

*Depreciation is a non-cash expense. Calculation assumes $400 is a capitalized investment depreciated over 5 years on a straight line basis and with no salvage value.

53

7. Calculate Discounted Cash Flow

A discount rate is used to determine the present value of future cash flow. Money has a time value! Time has a money value! Preset Value of an Investment Future Cash Flows (Factored by Discount Rate)

Discounted Cash Flow

54

Present Value and the Time Value of Money

Present value and the time value of money assume that a dollar in hand today is worth more than dollar to be received in the future.
Present Value simply discounts future cash flow based upon an assumed rate (i.e. discount rate, interest rate, hurdle rate or opportunity cost of capital). Net Present Value = C0 + C1 + C2 + C3 CN 1+r1 1+r2 1+r3 1+rN
10% Discount Rate Time Period (Years) Future Cash Flow Present Value (@10% discount rate) Net Present Value 20% Discount Rate Time Period (Years) Future Cash Flow Present Value (@20% discount rate) Net Present Value 0 $100 $100 $399 1 $100 $83 2 $100 $69 0 $100 $100 $479 Financial Analysis 3 $100 $58 4 $100 $48 5 $100 $40 Total $600 $399 1 $100 $91 2 $100 $83 Financial Analysis 3 $100 $75 4 $100 $68 5 $100 $62 Total $600 $479

The higher the discount rate the lower the present value of future cash flow.
55

8. Assess Alternatives Based on Financial Metrics

The next step is calculate, assess, and compare the financial results of each defined alternative. Confirm basic cash flow assumptions Confirm correctness of worksheet calculations Conduct sensitivity analysis on key parameters. Examples:
Discount rate Time horizon Magnitude of investment Probabilities of annual savings realized Probabilities operating costs required

Do a sanity check on the assumptions and the analysis before developing a presentation.
56

Results of Poor Financial Analysis

MISCALCULATION
Perhaps You Will Be Long Gone Before They Realize Your Mistake
57

Discounted Cash Flow and Net Present Value

Net Present Value (NPV) is determined by simply discounting annual net cash flows by the assumed discount rate. The higher the NPV the more favorable the investment.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows (Assumes Capital in Y0; Expense Y1) Net Cash Flow (Pre-Tax) Depreciation (5 Years) Net Operating Profit (Before Tax) Taxes (40%) Net Cash Flow (After Tax) Discounted Cash Flow* (using 10%) Net Present Value 0 $0 ($200) ($200) $0 $0 $0 ($200) ($200) $65 1 $0 ($100) ($100) ($40) ($140) $56 ($44) ($40) 2 $150 $0 $150 ($40) $110 ($44) $106 $88 3 $150 $0 $150 ($40) $110 ($44) $106 $80 4 $150 $0 $150 ($40) $110 ($44) $106 $72 5 $150 $0 $150 ($40) $110 ($44) $106 $66 Total $600 ($300) $300 ($200) $100 ($120) $180 $65

Project A

*Also considered as the Present Value of after tax cash flow.

58

Discounted Cash Flow and Net Present Value

Net Present Value (NPV) is determined by simply discounting annual net cash flows by the assumed discount rate. The higher the NPV the more favorable the investment.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows (Assumes Capital in Y0; Expense Y1) Net Cash Flow (Pre-Tax) Depreciation (5 Years) Net Operating Profit (Before Tax) Taxes (40%) Net Cash Flow (After Tax) Discounted Cash Flow* (using 10%) Net Present Value 0 $0 ($400) ($400) $0 $0 $0 ($400) ($400) $261 1 $0 ($100) ($100) ($80) ($180) $72 ($28) ($25) 2 $250 $0 $250 ($80) $170 ($68) $182 $150 3 $250 $0 $250 ($80) $170 ($68) $182 $137 4 $250 $0 $250 ($80) $170 ($68) $182 $124 5 $250 $0 $250 ($80) $170 ($68) $182 $113 6 $250 $0 $250 $0 $250 ($100) $150 $85 7 $250 $0 $250 $0 $250 ($100) $150 $77 Total $1,500 ($500) $1,000 ($400) $600 ($400) $600 $261

Project B

*Also considered as the Present Value of after tax cash flow.

59

Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is often used in conjunction with or in lieu of an NPV analysis. IRR is the rate at which the investment has a Net Present Value of $0 The lower the IRR the less favorable the investment. IRR is often compared against a companys threshold hurdle rate to determine whether the investment is worth pursuing.
NPV* $300

Project A
$300 $150 IRR=18.7%
15% 20% 25%

NPV*

Project B
NPV=$261

$150

NPV=$65

IRR=24.4% Return 30% Rate $0

5% 10% 15% 20% 25%

$0

5%

10%

Return 30% Rate

($150)

($150)

($300) *The assumed discount rate used for projects is 10%

($300) 60

Modified Internal Rate of Return

The Modified IRR attempts to overcome the conceptual inaccuracies in the IRR calculation to determine a more realistic expected rate of return. IRR is intuitively appealing but conceptually flawed.
Intuitively, the higher the return the better the investment And, IRR does not require an assumed discount rate (which is often difficult to agree on) However, comparing alternative investments by IRR alone does not consider the total return or NPV of each investment In addition, IRR assumes all positive cash flows can be reinvested at the IRR rate, which generally is a flawed assumption.

Instead, a more appropriate approach is to assume positive cash flows can be reinvested at:
The average rate of return of all company investments, or The company cost of capital rate.

This will result in a more conservative and realistic expected rate of return.
61

Modified Internal Rate of Return - Project A

In the example below, the MIRR is actually lower than the IRR because the expected reinvestment rate of 10% is lower than the IRR.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows (Assumes Capital in Y0; Expense Y1) Net Cash Flow (Pre-Tax) Depreciation (5 Years) Net Operating Profit (Before Tax) Taxes (40%) Net Cash Flow (After Tax) Discounted Cash Flow (using 10%) Net Present Value Internal Rate of Return (IRR) Modified IRR (w/10% reinvestment rate) 0 $0 ($200) ($200) $0 $0 $0 ($200) ($200) $65 18.7% 15.1% 1 $0 ($100) ($100) ($40) ($140) $56 ($44) ($40) 2 $150 $0 $150 ($40) $110 ($44) $106 $88 3 $150 $0 $150 ($40) $110 ($44) $106 $80 4 $150 $0 $150 ($40) $110 ($44) $106 $72 5 $150 $0 $150 ($40) $110 ($44) $106 $66 Total $600 ($300) $300 ($200) $100 ($120) $180 $65

The MIRR results in a more conservative and realistic expected rate of return
62

Modified Internal Rate of Return - Project B

In the example below, the MIRR is actually lower than the IRR because the expected reinvestment rate of 10% is lower than the IRR.
Financial Analysis Investment Life Span (Years) Cash Inflow Cash Outflows (Assumes Capital in Y0; Expense Y1) Net Cash Flow (Pre-Tax) Depreciation (5 Years) Net Operating Profit (Before Tax) Taxes (40%) Net Cash Flow (After Tax) Discounted Cash Flow (using 10%) Net Present Value Internal Rate of Return (IRR) Modified IRR (w/10% reinvestment rate) 0 $0 ($400) ($400) $0 $0 $0 ($400) ($400) $261 24.4% 17.7% 1 $0 ($100) ($100) ($80) ($180) $72 ($28) ($25) 2 $250 $0 $250 ($80) $170 ($68) $182 $150 3 $250 $0 $250 ($80) $170 ($68) $182 $137 4 $250 $0 $250 ($80) $170 ($68) $182 $124 5 $250 $0 $250 ($80) $170 ($68) $182 $113 6 $250 $0 $250 $0 $250 ($100) $150 $85 7 $250 $0 $250 $0 $250 ($100) $150 $77 Total $1,500 ($500) $1,000 ($400) $600 ($400) $600 $261

The MIRR results in a more conservative and realistic expected rate of return
63

Example Financial Analysis

Parameters for example ROI analysis:

$2,000 $1,000 $10,000 $9,000 $2,000 $5,000 7 Years 5 Years 7 Years 10% 40%

Marginal annual savings Marginal annual costs Inventory reduction Equipment investment Salvage value on equipment System investment with no salvage value Equipment depreciation using sum of years digits (SYD) System depreciation using sum of years digits (SYD) Cash flow horizon Discount rate Tax rate
64

Example Financial Analysis ROI Inputs

The input parameters are illustrated in the ROI template below: Example
ROI Inputs
Initial Investment Capital Expenditures (Depreciable) Building $ Equipment $ 9,000 Systems $ 5,000 Other CAPEX $ Total Capital Investment $ 14,000 Project Costs (Expensed) 0 External Expenses $ Internal Expenses $ Total Project Expenses $ Annual Marginal Savings 0 Category A Category B Category C Total Marginal Savings $ Annual Marginal Costs 0 Category A Category B Category C Total Annual Marginal Costs $ Change in Working Capital (One Time) 0 + Inventory Increase (Reduction) $ + A/R Increase (Reduction) $ - A/P Increase (Reduction) $ Total Change in Working Capital $ Discount Rate Inflation Rate Tax Rate Cash Flow Horizon (Years) 10.0% 0.0% 40.0% 7 Salvage Value $ $ 2,000 $ $ $ 2,000 1 $ $ $ 1 2,000 Useful Life 40 7 5 3 2 Selected Depr. Method SYD SYD SYD SYD 3 Optional Depr. Methods SLN Straight Line SYD Sum of Years Digits VDB Double Declining Balance MACRS Modified Accelerated Cost Recovery System

$ $

2 2,000

$ $

3 2,000

4 2,000

5 2,000

6 2,000

7 2,000

8 2,000

9 2,000

10 2,000

$ $

2,000 1 1,000

$ $

2,000 2 1,000

$ $

2,000 3 1,000

$ $

2,000 4 1,000

$ $

2,000 5 1,000

$ $

2,000 6 1,000

$ $

2,000 7 1,000

$ $

2,000 8 1,000

$ $

2,000 9 1,000

$ $

2,000 10 1,000

1,000 $ 1 $ (10,000)

1,000 2

1,000 3

1,000 4

1,000 5

1,000 6

1,000 7

1,000 8

1,000 9

1,000 10

$ (10,000) $

For ROI Calculations

65

Example Financial Analysis Depreciation

Depreciation Tables
Annual Depreciation Building Equipment Systems Other CAPEX Total Depreciation Building SLN SYD VDB MACRS Equipment SLN SYD VDB MACRS Systems SLN SYD VDB MACRS Other CAPEX SLN SYD VDB MACRS $ $ $ $ $ $ $ $ 0 $ $ $ $ $ $ $ $ 0 $ $ $ $ $ $ $ $ 0 $ $ $ $ 0 $ $ $ $ $ 0 $ $ $ $ $ $ $ $ $ 1 1,750 1,667 3,417 1 1 1,000 1,750 2,571 1,286 1 1,000 1,667 2,000 1,000 1 $ $ $ $ $ $ $ $ $ $ $ $ $ 2 1,500 1,333 2,833 2 2 1,000 1,500 1,837 2,204 2 1,000 1,333 1,200 1,600 2 $ $ $ $ $ $ $ $ $ $ $ $ $ 3 1,250 1,000 2,250 3 3 1,000 1,250 1,312 1,574 3 1,000 1,000 720 960 3 $ $ $ $ $ $ $ $ $ $ $ $ $ 4 1,000 667 1,667 4 4 1,000 1,000 937 1,124 4 1,000 667 540 576 4 $ $ $ $ $ $ $ $ $ $ $ $ $ 5 750 333 1,083 5 5 1,000 750 343 804 5 1,000 333 540 576 5 $ $ $ $ $ $ $ $ $ $ $ $ $ 6 6 1,000 500 803 6 $ $ $ $ 6 $ $ $ $ 288 $ $ $ $ 7 $ $ $ $ $ $ $ $ 6 500 500 $ $ $ $ $ 7 7 1,000 250 804 7 $ $ $ $ 8 $ $ $ $ $ $ $ $ 8 $ $ $ $ 8 $ $ $ $ 9 $ $ $ $ 401 $ $ $ $ 9 $ $ $ $ 10 $ $ $ $ 7 250 250 $ $ $ $ $ 8 $ $ $ $ 9 $ $ $ $ 10 $ $ $ $ 8 $ $ $ $ $ 9 $ $ $ $ 10 $ $ $ $ 9 $ $ $ $ $ 10 $ $ $ $ 10 $ $ $ $ $ Totals 7,000 5,000 12,000 Totals Totals 7,000 7,000 7,000 9,000 Totals 5,000 5,000 5,000 5,000 Totals -

$ $ $ $

$ $ $ $

$ $ $ $

$ $ $ $

$ $ $ $

$ $ $ $

$ $ $ $

$ $ $ $

$ $ $ $

$ $ $ $

MACRS Table Recovery Year 3 5 7 10 15 20 40

1 33.33% 20.00% 14.29% 10.00% 5.00% 3.75% 2.57%

2 44.45% 32.00% 24.49% 18.00% 9.50% 7.22% 2.57%

3 14.81% 19.20% 17.49% 14.40% 8.55% 6.68% 2.57%

4 7.41% 11.52% 12.49% 11.52% 7.70% 6.18% 2.57%

5 11.52% 8.93% 9.22% 6.93% 5.71% 2.57%

6 5.76% 8.92% 7.37% 6.23% 5.29% 2.57%

10

11

8.93% 6.55% 5.90% 4.89% 2.57%

4.46% 6.55% 5.90% 4.52% 2.57%

6.56% 5.91% 4.46% 2.57%

6.55% 5.90% 4.46% 2.57%

3.28% 5.91% 4.46% 2.57%

66

Example Financial Analysis ROI Outputs

Example

ROI Outputs
0 Income Statement Cash Flow Marginal Savings Marginal Costs & Project Expenses Net Savings (pre Depr. & Taxes) Depreciation Expenses (non Cash) Net Operating Profit (pre-Taxes) Income Taxes Net Income (NOPAT) Cash Flow from Operations Balance Sheet Cash Flow Capital Investments (Depreciable) Change in Working Capital Cash Flow from Balance Sheet Net Cash Flow Accumulated Cash Flow Discounted Cash Flow (DCF) Accumulated DCF Net Present Value (NPV) IRR MIRR Simple Payback Period (Years) Discounted Payback Period (Years) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 1 2,000 (1,000) 1,000 (3,417) (2,417) 967 (1,450) 1,967 $ $ $ $ $ $ $ $ 2 2,000 (1,000) 1,000 (2,833) (1,833) 733 (1,100) 1,733 $ $ $ $ $ $ $ $ 3 2,000 (1,000) 1,000 (2,250) (1,250) 500 (750) 1,500 $ $ $ $ $ $ $ $ 4 2,000 (1,000) 1,000 (1,667) (667) 267 (400) 1,267 $ $ $ $ $ $ $ $ 5 2,000 (1,000) 1,000 (1,083) (83) 33 (50) 1,033 $ $ $ $ $ $ $ $ 6 2,000 (1,000) 1,000 (500) 500 (200) 300 800 $ $ $ $ $ $ $ $ 7 2,000 (1,000) 1,000 (250) 750 (300) 450 700 $ $ $ $ $ $ $ $ 8 2,000 (1,000) 1,000 1,000 (400) 600 600 $ $ $ $ $ $ $ $ 9 2,000 (1,000) 1,000 1,000 (400) 600 600 $ $ $ $ $ $ $ $ 10 2,000 (1,000) 1,000 1,000 (400) 600 600

$ (14,000) $ - $ $ (14,000) $ $ $ $ $ $ (14,000) (14,000) (14,000) (14,000) 1,756 17.6% 11.9% 2.2 3.6 $ $ $ $

10,000 10,000 11,967 (2,033) 10,879 (3,121)

$ $ $ $ $ $

1,733 (300) 1,433 (1,689)

$ $ $ $ $ $

1,500 1,200 1,127 (562)

$ $ $ $ $ $

1,267 2,467 865 303

$ $ $ $ $ $

1,033 3,500 642 945

$ $ $ $ $ $

800 4,300 452 1,397

$ $ $ $ $ $

700 5,000 359 1,756

$ $ $ $

$ $ $ $

$ $ $ $

(must manually adjust # of years to assess)

67

Economic Value Added (EVA)

Economic Value Added (EVA) is another metric used to evaluate the return of a company or investment. EVA promotes the simple goal of generating more profit with the same or less capital requirement EVA equals Net Operating Profit After Taxes (NOPAT) less the opportunity cost of capital It compares the return on the investment vs. the average return on other investment opportunities EVA must be positive to be considered a potential worthwhile investment Calculation Terms:
EVA = NOPAT WACC * Invested Capital, where NOPAT = Operating profit x (1 - Tax Rate) WACC = weighted avg. cost of capital (discount rate of debt and equity) Invested Capital = Annual net change in assets associated with investment
68

EVA - NOPAT from Income Statement

The Net Operating Profit After Taxes (NOPAT) is the operating income less the taxes associated with the operating income. Example: Example
Income Statement Revenue $2,000 Cost of Good Sold (COGS) ($1,000) Gross Income $1,000

Gross Margin
Operating Expenses (SG&A)*

50% ($400) $600 ($200) $400 20% Selling, general, and administrative costs Earnings before interest, taxes, depreciation and amortization Non Cash Expense (*often embedded in SG&A) Also referred to as EBIT

EBITDA
*Depreciation Operating Income

Operating Margin
Other Non-Operating Expenses Other Non-Operating Revenue

EBIT
Interest Expense Net Profit Before Taxes Taxes (40%) Net Income

($20) $40 $420 Earnings before interest and taxes ($50) $370 $148 $222 11%

Non-operating costs and revenues, and their proportional taxes, are excluded from NOPAT.

Profit Margin
NOPAT

$240 Net Operating Profit After Tax = Operating Income * (1-Tax Rate) 69

EVA - NOPAT from Project

The Net Operating Profit After Taxes (NOPAT) is different than cash flow because it includes the non-cash flow expense of depreciation. Example
Project NOPAT
Marginal Savings Marginal Costs & Project Expenses $ $ 0 $ $ $ $ $ $ $ $ 1 2,000 $ 2 2,000 $ 3 2,000 $ 4 2,000 $ 5 2,000

(1,000) $ 1,000 $

(1,000) $ 1,000 $

(1,000) $ 1,000 $

(1,000) $ (1,000) 1,000 $ 1,000

Net Savings (pre Depr. & Taxes) $ Depreciation Expenses (non Cash) $

(2,286) $ (1,286) $ 514 $

(3,804) $ (2,804) $ 1,122 $

(2,534) $ (1,534) $ 614 $

(1,700) $ (1,380) (700) $ 280 $ (380) 152 (228) 1,152

Net Operating Profit (pre-Taxes) $ Income Taxes $

Project Net Operating Profit After Taxes $ Cash Flow from Operations $

(772) $ 1,514 $

(1,682) $ 2,122 $

(920) $ 1,614 $

(420) $ 1,280 $

70

EVA Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the minimum return that a company must earn.
WACC is calculated as the proportional cost of debt vs. equity. WACC = wd*(1-T)* rd + we*re
wd = debt portion of value of corporation T = tax rate rd = cost of debt (rate) we = equity portion of value of corporation re = cost of internal equity (rate) The company has 40% debt and 60% equity Shareholders expect a 8% return for their investment in company shares The company pays pay 5% interest for debt. Tax rate is 40% WACC = 40%*(1-40%)*5% + 60%*8% = 6%

Example:

For simplicity, the discount rate may be used when calculating the EVA on a project investment
71

EVA Invested Capital on Balance Sheet

Invested capital is equivalent to total assets (or total liability and equity) less non-interest bearing current liabilities (NIBCL). Example
Invested capital is the total cash based investment NIBCL is free money debt, representing money that the company owes and must pay within one year and does not require interest payments Examples of NIBCL:
Accounts payable Unpaid taxes due by the end of the year
Assets Cash Securities Accounts Receivable Inventory Prepaid Expenses Other Current Assets Total Current Assets Long Term Investments Property, Plant & Equipment Intangible Assets Total Assets Liabilities Short Term Debt Accounts Payable Taxes Payable Other Payables Total Current Liabilities Long Term Debt $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 4,200 2,800 16,600 49,000 1,600 3,300 77,500 8,700 76,000 10,000 172,200 5,000 19,800 1,000 6,300 32,100 50,000 82,100 70,000 3,700 16,400 90,100 172,200

NIBCL

In the example, Invested Capital: $172,200 - $27,100 = $145,100

$ Total Liabilities $ $ $ $ Total Equity $

Equity Capital Stock Additional Paid in Capital Retained Earnings

Total Debt & Equity $

72

EVA Invested Capital for a Project

Invested capital for a project can be defined as the annual book value of all assets impacted by the project.
EVA determines whether the net profit of an investment exceeds the opportunity cost of the capital for that investment Invested capital for a project can be considered as the CAPEX plus the sustainable, net change in working capital (inventory, A/P, A/R). The assumption is that there is an opportunity cost interest charge (i.e. discount rate or WACC) associated with any net change in capital.

Example
Capital Expenditures (Depreciable) Equipment Systems Total Capital Investment Annual Depreciation Equipment Systems Total Depreciation Asset Book Value Equipment Systems Ending Book Value Working Capital Change in Working Capital Project Invested Capital Long Term Assets Working Capital Net Invested Capital Initial Investment $ 9,000 $ 5,000 $ 14,000 0 $ $ $ $ $ $ $ $ $ 0 9,000 5,000 14,000 0 0 14,000 14,000 $ $ $ $ $ $ $ $ $

1 1,286 1,000 2,286 1 7,714 4,000 11,714 1 (10,000) 1 11,714 (10,000) 1,714 $ $ $ $ $ $ $ $ $

2 2,204 1,600 3,804 2 5,510 2,400 7,910 2 (10,000) 2 7,910 (10,000) (2,090)

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EVA Project Example

The example below illustrates the EVA calculation for project investment.
EVA Output
Capital Expenditures (Depreciable) Building Equipment Systems Other CAPEX Total Capital Investment Annual Depreciation Building Equipment Systems Other CAPEX Total Depreciation Asset Book Value Building Equipment Systems Other CAPEX Ending Book Value Inventory + Inventory Increase (Reduction) + A/R Increase (Reduction) - A/P Increase (Reduction) Total Change in Working Capital Project Invested Capital Long Term Assets Working Capital Net Project Invested Capital Economic Valued Added Capital Charge of Invested Capital NOPAT EVA Discounted EVA NPV of EVA Initial Investment $ $ 9,000 $ 5,000 $ $ 14,000 0 $ $ $ $ $ 0 $ $ 9,000 $ 5,000 $ $ 14,000 0 $ 0 0 $ 0 $ 14,000 $ 14,000 0 (1,400) (1,400) (1,400) (389) Salvage Value $ $ 2,000 $ $ $ 2,000 1 $ $ 1,286 $ 1,000 $ $ 2,286 1 $ $ 7,714 $ 4,000 $ $ 11,714 1 $ (10,000) $ $ $ (10,000) 1 $ 11,714 $ (10,000) 1,714 1 (171) (772) (943) (857) Useful Life 40 7 5 3 2 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 2,204 1,600 3,804 2 5,510 2,400 7,910 2 (10,000) (10,000) 2 7,910 (10,000) (2,090) 2 $ $ $ $ 209 (1,682) (1,473) (1,218) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Selected Depr. Method MACRS MACRS MACRS MACRS 3 1,574 960 2,534 3 3,936 1,440 5,376 3 (10,000) (10,000) 3 5,376 (10,000) (4,624) 3 462 (920) (458) (344) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 4 1,124 576 1,700 4 2,812 864 3,676 4 (10,000) (10,000) 4 3,676 (10,000) (6,324) 4 632 (420) 212 145 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 5 804 576 1,380 5 2,008 288 2,296 5 (10,000) (10,000) 5 2,296 (10,000) (7,704) 5 770 (228) 543 337 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 6 803 288 1,091 6 1,205 1,205 6 (10,000) (10,000) 6 1,205 (10,000) (8,795) 6 879 (54) 825 466 $ $ $ $ $ $ $ $ $ 7 $ $ $ $ $ 401 401 $ $ $ $ $ 7 804 804 $ $ $ $ $ 8 $ $ $ $ $ 8 401 401 $ $ $ $ $ 9 $ $ $ $ $ 9 $ $ $ $ $ 10 10 -

7 8 $ (10,000) $ (10,000) $ $ $ $ $ (10,000) $ (10,000) 7 8 $ 401 $ $ (10,000) $ (10,000) (9,599) (10,000) 7 960 118 1,078 553 $ $ $ $ 8 1,000 359 1,359 634

9 10 $ (10,000) $ (10,000) $ $ $ $ $ (10,000) $ (10,000) 9 10 $ $ $ (10,000) $ (10,000) (10,000) (10,000) 9 1,000 600 1,600 679 10 1,000 600 1,600 617

$ $ $ $ $

$ $ $ $

$ $ $ $

$ $ $ $

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9. Conduct Qualitative Analysis

A business case is more than the numbers; it must address other factors that weigh in the final decision.
Decision making requires a connection between the left brain (logical side) and the right brain (intuitive, creative, and holistic side) We cannot expect executives to make a decision if we only address one half of their decision making requirements Therefore, we must also address the qualitative aspect of the business case. Example considerations:
Priority of Investment Business Climate Critical Success Factors Feasibility of Assumptions Risks Resource Availability Executive Preferences Intangible Benefits

As a rule of thumb, we should answer the questions we would ask ourselves if we had to put on own money on the line.
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10. Package the Business Case

Example components of a board level business case:
Statement defining purpose of meetingmake sure they understand what you expect of them Overview of project scope and objectivesput the discussion in context Overview of project analysis & resultsbriefly describe how you got to this point Key business assumptionssummarize major assumptions that lead to your recommendation Recommendationclearly state what you recommend and why Anticipated Benefitsput in terms important to the audience
Financial Key Metrics Qualitative Financial Organizational

Required Investmentdefine how much, when, and who

Financial analysissummarize the results of the discounted flow assessment Critical success factorsaddress risks and mitigating actions leadership should take Project roadmapcreate a summary gantt chart of major work streams Supporting analysis and assumptions (appendices)organize in a separate file or document for easy access

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Ten Checklist Questions

These ten questions make a good checklist when reviewing a business case. 1. Does the business case address a key business priority? 2. Are the scope and objectives of the business class clear? 3. Are the cash flow projections and financial analysis clearly defined? 4. Is the supporting analysis easy to follow? 5. Are the assumptions credible? 6. What other alternatives were considered? 7. What are the critical success factors? 8. How will it be implemented? 9. What are the risks? 10. What actions are expected of the decision maker?

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Questions?

Questions
The Answer To A Good Question Can Illuminate A Room Full Of Dim Bulbs
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