Article by: Lonehill Accountant: Jean Claude Marais
As SMEs and Mid-Market entities grow, strategic expansion becomes more crucial to ensure sustained shareholder value. This results in management being faced with significant decision-making and analysis, which requires a deeper understanding of how projects are evaluated and presented to the board of directors.
In this article, I will attempt to address the process of decision-making process and techniques used in the project analysis exercise.
Initial appraisal
Firstly, management should use a simple project evaluation technique such as Payback or Accounting Rate of Return (“ARR”).
Payback Period
This is a simple initial screening process used to determine the merit of the project and should be further subjected to more sophisticated techniques, which will be discussed below. The Payback period determines the time required for the cash inflows from the project to match or equal the cash outflows from the project. This however does not account for the time value of money and any period after the payback period is ignored. To assess the initial merit of a project the payback period should be compared to the company’s target payback back period. This however does pose some disadvantages as the selected target payback period can be arbitrary and subjective. Uncertainty is accounted for in this analysis as future cashflows are more uncertain.
Accounting Rate of Return
This is also an easy initial screening process, that looks at the entire project life and should be followed by more sophisticated appraisal techniques which will be discussed in this article. The Accounting rate of return is determined by dividing the Average annual PBIT by the initial or Average investment (Cash Inflow), which should then be compared to the company’s target ARR. However, this also carries some risk as the profit can be manipulated and there are also no considerations made for the time value of money.
Calculation:
ARR = Average Annual PBIT/Initial or average investment
Discounted cash flow techniques (More sophisticated)
Receiving R100 in the future is worth less than receiving R100 today, this is the concept known as the “Time Value of Money”. Techniques that can assist with analyzing a project which accounts for the time value of money, are Net Present Value (“NPV”) and Internal Rate of Return (“IRR”).
Net Present Value (“NPV”)
The NPV technique compares the present value of all cash inflows with the present value of the cash outflows of the project. Essentially it represents a change in wealth or the investors in the project. This appraisal technique is an absolute measurement allowing a comprehensive comparison between projects, taking into account both the whole life of the project and the time value of money.
The NPV technique does however have more complex factors that would need to be included in the analysis such as the determination of the cost of capital and it can be difficult to determine a cost to benefit analysis. The technique also assumes that the cash flows are in annual intervals.
How do you interpret the result of an NPV evaluation?
A positive NPV means that the present value of the cash inflow from the evaluated project is greater than the investment (cash outflow), resulting in an increase of wealth to the investors in the project. Similarly, a Negative NPV has a greater cash outflow resulting in a decrease of wealth for the Investor.
A zero NPV means that the project’s return is equal to the Internal Rate of return and would most likely not result in a change of wealth to the investor. A project with a zero NPV should only be undertaken for non-financial strategic reasons, such as an increase in market share.
Internal Rate of Return (“IRR”)
The IRR is the annual percentage return, at which the sum of the discounted cash inflow equals the discounted cash outflow; non-conventional cash flows are not accounted for in this technique. During the life of the project the cost of capital rises, and the present value of the cash inflows falls it will eventually fall to zero. Therefore, a project should only be accepted if the IRR is greater than the Cost of Capital.
This technique is easy to understand, and the discount rate does not need to be determined before the analysis, as a hurdle rate may be used in the analysis. This however ignores the relative size of the project and that the cash flows are reinvested elsewhere at the IRR.
Conflicts between IRR and NPV can arise, however taking into account the disadvantages of IRR, NPV should be used as it is intrinsically more reliable than IRR.
Additional considerations
When utilizing Discounted Cash Flow analysis techniques, the analysis should take into account various aspects when undertaking the analysis. Taxation should be considered due to the effects of both tax payments and savings on operating profit and the tax savings due to tax allowable depreciation or capital allowances on capital expenditure.
Another aspect to consider is the working capital or the change in working capital. The effect on cash flow would be due to the required capital “injection” during the project’s life with an increase in working capital required that will increase the cash outflow required.
Finally, Inflation should also be considered when analysing projects, however, this is limited to the amount of inflation rates applicable to the project. If only one rate is applicable there would be insignificant or no net effect on the NPV and the inflation effect can be ignored.
#CorporateFinance #ProjectAppraisal #FinancialManagement
To contact Jean Claude Marais: send email or call the office: 082 265 5408 or cell: 067 244 9692
