Transcript Project Profitability Assessment 1

Project Profitability
Assessment
1
Contents
 Capital budgeting (of “environmental”
projects)
 Project cash flows and simple payback
 The Time Value of Money (TVM) and
Net Present Value (NPV)
 Two small group exercises
 Capital budgeting with inflation and tax
 Sensitivity analysis
 Key profitability indicators
2
Capital Budgeting
(of “Environmental” Projects)
[15 min]
3
Capital budgeting
The process by which an organization:
 Decides which investment projects are
needed & possible, with a special focus
on projects that require significant upfront investment (i.e., capital)
 Decides how to allocate available
capital between different projects
 Decides if additional capital is needed
4
Capital budgeting practices
 Capital budgeting practices vary widely
from company to company
– Larger companies tend to have more formal
practices than smaller companies
– Larger companies tend to make more and
larger capital investments than smaller
companies
– Some industry sectors require more capital
investment than others
 Capital budgeting practices may also vary
from country to country
5
Typical project types & goals (1)
 Maintenance
– Maintain existing equipment and operations
 Improvement
– Modify existing equipment, processes, and
management and information systems to
improve efficiency, reduce costs, increase
capacity, improve product quality, etc.
 Replacement
– Replace outdated, worn-out, or damaged
equipment or outdated/inefficient management
and information systems
6
Typical project types & goals (2)
 Expansion
– e.g., obtain and install new process
lines, initiate new product lines
 Safety
– make worker safety improvements
 Environmental
– e.g., reduce use of toxic materials,
increase recycling, reduce waste
generation, install waste treatment
 Others...
7
The poor reputation of
“environmental” investment projects
Many people in industry view
“environmental” projects as increasingly
necessary to stay in business, but as
automatic financial losers because:
– they associate “environmental projects” with
pollution control systems such as wastewater
treatment plants, which can be quite costly
(end-of-pipe)
– they are unaware of the potential financial
benefits of preventive environmental
management practices
8
We know better!
 We have learned that some environmental
projects, i.e., Cleaner Production (CP)
projects, can go hand in hand with:
– Production efficiency improvements
– Product quality improvements
– Production expansion
 So, do not place your project idea into a
single narrow category — think broadly
about all the possible benefits
9
Decision-making factors
Technical
Regulatory
Project
selection
Today’s focus
Financial
Organizational
10
Project Cash Flows
and
Simple Payback
[15 min]
11
The Cash Flow Concept
The Cash Flow Concept is a common
management planning tool.
It distinguishes between:
(a) costs -> cash outflows
(b) revenues/savings -> cash inflows
12
Cash Flow Analysis
• Relies on every day life principles
• Measures the difference between
– What we received, and
– What we paid out
• Only cash receipts and cash payments are
included in the analysis
• Applicable also to forecast cash available 13
Types of Cash Flows
Outflow
Inflow
One-time
Initial
investment
cost
Equipment
salvage
value
Annual
Operating
costs &
taxes
Operating
revenues
& savings
Other
Working
capital
Working
capital
14
Cash Outflow Analysis (1)
INITIAL INVESTMENT
• Planning/ Engineering
• Utility Systems &
• Permitting
Connections
• Site Preparation
• Start-up/Training
• Purchased Equipment
• Contingency
• Working Capital
• (Salvage Value)
15
Working Capital
Working Capital is: “the total value of
goods and money necessary to maintain
project operations”
It includes items such as:
–
–
–
–
Raw materials inventory
Product inventory
Accounts payable/receivable
Cash-on-hand
16
Salvage Value
Salvage Value is the resale value of
equipment or other materials at the
end of the project
17
Cash Outflow Analysis (2)
•Direct costs
•Input costs
•Other costs
•Loan repayments
•Interest on loan application
18
Cash Inflow Analysis
•Sales
•Savings
•Salvage value
•Cash shortfall / surplus
19
Cash Flow Forecast/Projection
(1)
•We are looking at the likely future
cash position.
•We examine the possible effects of
changes in the cash flow components .
20
Cash Flow Forecast/Projection
(2)
 Make assumptions about likely outcomes
regarding:
– Inflation
– Market size
– Demand for goods and services
– Interest Rates
21
Cashflow Projection Worksheet
Investment Year
0
1
2
3
INITIAL INVESTMENT
Total Investment Costs
OPERATING COSTS
Total Operating Costs
OPERATING AND MAINTENANCE
Total Operating and Maintenance Costs
WASTE MANAGEMENT
Total Waste Management Costs
COMPLIANCE AND REG. (Less
Tangibles)
Total Compliance Costs
REVENUES AND SAVINGS
REVENUES
Operating Costs
Less Depreciation
Taxable Income
Tax payable
Net Income after Depreciation and Tax
22
Annual Operating Costs & Savings
(see also Cleaner Production Investment Decision: Costs and
Savings checklist)
Operating
Inputs
• Materials
• Energy
• Labour
• Floor Space
• Taxes
• Depreciation
Waste Management
Less Tangibles
• Materials
• Potential liability
• Insurance
includes waste handling, recycling, • Productivity
treatment, disposal, and regulatory • Future regulation
compliance
• Energy
• Labour
• Floor space
• Fees
• Company image
Revenues
• Product sales
• By-product sales
• Pollution credits
• Taxes & Depreciation
• Cost of capital • Cost of Capital
23
Timing of Cash Flows
End of project:
Salvage Value
Annual Revenues/Savings
Working
capital
Year 1
Year 2
Year 3
TIME
Annual Operating Costs
Annual Tax Payments
Time zero:
Annual Financing
Working Capital
Payments
Initial Investment
24
Cash Flow Analysis structure
There are two basic ways to structure
a project financial analysis:
1) Stand-alone analysis
Considers only the cash flows of the proposed
project
2) Incremental analysis
Compares the cash flows of the proposed
project to the “business as usual” cash flows
25
Incremental analysis for CP
 For many CP projects, you will need
to do an incremental analysis —
compare the CP cash flows to the
“business as usual” cash flows
 You only need to estimate the cash
flows that change when you improve
the “business as usual” operations
26
Profitability indicators
A profitability indicator, or “financial
indicator”, is: “a single number that is
calculated for characterisation of
project profitability in a concise,
understandable form.”
Common examples are:
• Simple Payback
• Return on Investment (ROI)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
27
Simple payback
This indicator incorporates:
– the initial investment cost
– the first year cash flow from the
project
Simple
Payback
(in years)
=
Initial Investment
Year 1 Cash Flow
28
How to interpret
simple payback
The simple payback calculated for a
project is usually compared to a
company rule of thumb called a
“hurdle” rate:
e.g., if the payback period is less
than 3 years, then the project is
viewed as profitable
29
Small Group Exercise:
Profitability Assessment
at the PLS Company— Part I
“Cash Flows & Simple Payback”
[30 min]
30
The PLS company’s
QC camera project
 PLS decided to purchase and install a
camera system to monitor quality control
(QC) of the print jobs as they actually
occur
 Allows the operators to detect print
errors earlier and halt the operations
before too much solid scrap is generated
 Has reduced generation of full-run solid
scrap by about 40%
31
Costs and savings
included in the QC camera analysis
 Initial investment costs
– purchase of the camera system,
delivery, installation, start-up
 Annual operating costs (and savings)
– Operating input — materials (plastic
film, ink), energy, labour
– Incineration — fuel, fuel additive,
labour, ash to landfill
– Wastewater treatment — chemicals,
electricity, labour, sludge to landfill
32
QC camera project
Cash flows
Annual savings = ???
Year 1
Year 2
Year 3
TIME
Annual Tax Payments = 0 (PLS has tax holiday)
Financing Payments = 0 (PLS paid cash)
Time zero:
Working Capital = 0 (not important for this project)
Initial Investment = $105,000
33
The PLS company’s
QC camera project
Initial
Investment
Cost
Business
As
Usual
The QC
Camera
Project
Annual
Operating
Costs
0
???
US $ 105,000
???
Annual
Savings =
???
34
Exercise instructions
Part I
 Introduction (5 min.), detailed in
your handout
 Question 1 (15 min.)
 Question 2 (5 min.)
 Discuss your answers with the
other small groups and the
instructor (5 min.)
35
The Time Value of Money
and
Net Present Value (NPV)
[30 min]
36
Question:
If we were giving away money,
would you rather have:
(A) $10,000 today, or
(B) $10,000 3 years
from now
Explain your answer...
37
Inflation
Money loses purchasing power over time
as product/service prices rise, so a
dollar today can buy more than a dollar
next year.
inflation 5%
costs $1
now
costs $1.05
next year
38
Investment opportunity
A dollar that you invest today will bring
you more than a dollar next year —
having the dollar now provides you with
an investment opportunity
Investing
$1 now
Investment
Gives you
$1.10 a year
from now
Interest, or
“return on investment”
39
Time Value of Money (TVM)
 Money now is worth more than
money in the future because
of:
a) inflation
b) investment opportunity
 The exact “time value” of your
money depends on the
magnitude of the:
a) rate of inflation and
b) rate of return on investment
40
TVM and project profitability
 When you invest in a capital project,
you have:
(1) An initial investment happening NOW
(2) A series of future cash inflows, over
time, that pay back the initial investment
 So, it is important to take the Time
Value of Money (TVM) into account
when you are estimating project
profitability
41
The PLS company’s
QC camera project
Initial
Investment
Cost
Business
As
Usual
The QC
Camera
Project
Annual
Operating
Costs
0
$ 2,933,204
$ 105,000
$ 2,894,741
(in US$)
Annual
Savings =
US$38,463
42
Question:
Is the annual savings of
$38,463 per year for 3 years
a sufficient return
on the initial investment of
$ 105,000?
43
Answer?
You might think about adding up the
annual savings over the 3 years:
Savings per year
Total savings
$38,463
x 3 years
$115,389
But: this ignores the Time Value of Money
(the fact that $38,463 in year 1 is not the
same as $38,463 in year 2 or year 3)
44
Comparing cash flows
from different years
 Before you can compare cash flows
from different years, you need to
convert them all to their equivalent
values in a single year
 It is easiest to convert all project
cash flows to their “present value”
now, at the very beginning of the
project
45
Converting the PLS cash flows
to their “present value”
Annual Savings
= ??
= ??
= ??
$38,463
Year 1
Year 2
End of project
$38,463
Year 3
$38,463
TIME
Time zero:
Initial Investment = $105,000
46
Converting cash flows
to their present value
 You can convert future year cash
flows to their present value using a
“discount rate” that incorporates:
– Desired return on investment
– Inflation
 The discount rate calculation is simple
— mathematically, it is the reverse of
an interest rate calculation
47
Interest rate calculation
Invested at an interest rate of 20%, how
much will $10,000 now be worth after 3
years?
After
year
1
$10,000 x 1.20
= $12,000
2
$10,000 x 1.20 x 1.20
= $14,400
3
$10,000 x 1.20 x 1.20 x 1.20 = $17,280
Note: these calculations are on a compound basis
48
Discounting calculation
The discounting calculation is essentially
the opposite of the interest rate
calculation.
If you want to have $17,280 in 3 years,
how much would you have to invest now?
$17,280
1.20 x 1.20 x 1.20
=
$10,000
needed now
In other words, $17,280 in year 3 has a
present value of $10,000
49
Which discount rate? (1)
 The discount rate a company chooses
should be equal to the required rate of
return for the project investment
 The required rate of return will usually
incorporate three distinct elements:
– A basic return - pure compensation for
deferring consumption
– Any ‘risk premium’ for that project’s risk
– Any expected fall in the value of money over
time through inflation
50
Which discount rate? (2)
 At a minimum, the chosen discount rate
should cover the costs of raising the
investment financing from investors or
lenders (i.e. the company’s “cost of
capital”)
 Often, rather than trying to identify the
exact source of capital (and its associated
cost) for each individual project, a firm
will develop a single “Weighted Average
Cost of Capital” (WACC) that characterises
the sources and cost of capital to the
company as a whole.
51
Discounting (1)
The value of the
cash flow in year n
Present Value = Future Valuen
(1 + d)n
The value of the
cash flow at
“Time Zero,” i.e.,
at project start-up
d = the
discount rate
n = the number
of years after
project start-up
52
Discounting (2)
The value of the
cash flow in year n
Present Value = Future Valuen x (PV Factor)
The value of the
cash flow at
“Time Zero,” i.e.,
at project start-up
Present Value (PV) Factors have
been calculated for various
values of d (discount rate) and n
(number of years) and have been
tabulated for easy use.
(Also called discount factors)
53
PresentValue factors
Value of $1 in the future, NOW
Discount rate (d): 10%
20%
30%
40%
.8333
.6944
.5787
.4823
.4019
.1615
.0261
.0042
.7692
.5917
.4552
.3501
.2693
.0725
.0053
.0004
.7142
.5102
.3644
.2603
.1859
.0346
.0012
.0000
Years into future (n)
1
2
3
4
5
10
20
30
.9091
.8264
.7513
.6830
.6209
.3855
.1486
.0573
54
Net Present Value (NPV)
 Net Present Value (NPV) = the sum of
the present values of all of a project’s
cash flows, both negative (cash
outflows) and positive (cash inflows)
 NPV characterises the present value of
the project to the company
If NPV > 0, the project is profitable
If NPV < 0, the project is not
55
Estimating
Net Present Value
Year
Expected
Future Cash
Flows
0
- $105,000
???
- $???
1
+ $38,463
???
$???
2
+ $38,463
???
$???
3
+ $38,463
???
$???
*
PV
Factor
=
Present Value of
Cash Flows
(at time zero)
Sum = the project’s Net Present Value =
$???
56
Time for lunch!
[60 min]
57
Small Group Exercise:
Profitability Assessment
at the PLS Company— Part II
“Net Present Value”
[45 min]
58
Also —
you will need the handout:
“Performing Net Present Value
(NPV) Calculations”
Located in your handout
59
Converting the PLS cash flows
to their “present value”
End of project
= ??
= ??
= ??
$38,463
Year 1
Year 2
$38,463
Year 3
$38,463
TIME
Time zero:
Initial Investment = $105,000
60
Exercise instructions
Part II
 Introduction (5 min.), detailed in
your handout
 Question 3 (15 min.)
 Question 4 (5 min.)
 Discuss your answers with the
other small groups and the
instructor (15 min.)
 Lessons learned (5 min.)
61
Capital Budgeting:
inflation & tax
[30 min]
62
Discounting and inflation (1)
 even without inflation, money has a
time value due to supply/demand for
money
 inflation increases both:
- future cash flows
- interest rates (and  discount rates)
 these offset each other
63
Discounting and inflation (2)
With 10% inflation (say), future cash flows
will  by 10% each year
Investors & lenders will also require a higher
rate to compensate for their loss in
purchasing power
If 15% was acceptable with no inflation, with
10% inflation they will now require
115% x 110% = 126.5%
64
Discounting and inflation (3)
PLS Company, now assuming 10% inflation and 26.5%
discount rate:
Year
1
2
3
Cash flow
($)
42,309
46,540
51,194
PV factor
@ 26.5%
0.791
0.625
0.494
less: initial investment
Net Present Value
PV
($)
33,466
29,088
25,289
87,843
105,000
-17,157
i.e. same NPV* as with zero inflation, 15% discount rate
* ignoring minor rounding difference
65
What is the current rate of inflation in
the economy?
What return on their capital will the
lender really earn on their money,
after allowing for the erosion of their
capital over time through inflation?
66
Tax payments
 Taxes can be an important project
cash flow
 Depending on a facility’s location, a
firm may have to pay national and/or
local income taxes on the revenues or
savings generated by a project
 Other types of taxes may also be
relevant - sales taxes, pollution
taxes, etc.
67
Tax deductions or credits
 Tax deductions or credits can also be
important
 One example is the income tax
deduction often given for equipment
depreciation, which is the loss in value
of a physical asset (e.g., a piece of
equipment) as the asset ages
 Some “environmental” investments can
receive special tax credits
68
Tax and project appraisal
 assume 30% rate of taxes of firms’
profits
 tax is based on accounting profits, not
on cashflows
 accounting profits are after deducting
depreciation
 tax is payable 1 year after the
profits have been realised
69
Depreciation
 A project needs $12,000 for a new
machine which will last 3 years
 assume the machine has no residual
value after 3 years
 depreciation per year:
initial cost = $12,000 = $4,000 per year
asset life
3 years
70
Profit earned by project
 Profit earned by project in each year:
cash inflow per year
less: depreciation
$6,000
$4,000
contribution to profit
$2,000
tax @ 30%
$600
71
NPV of project, with tax
time
now
1
2
3
4
cash
tax
net
-12,000
-12,000
+6,000
+6,000
+6,000 -600 +5,400
+6,000 -600 +5,400
-600
-600
PV
factor
PV
1.000
0.833
0.694
0.579
0.482
-12,000
+5,000
+3,750
+3,125
-289
Net Present Value
- $414
72
Project appraisal with inflation
and tax
 depreciation (and accounting profits) are
based on the asset’s original cost
 the asset’s original cost does not increase
with inflation over the life of the project
 project analysis is then easier using
nominal (not real) cashflows and discount
rates
73
Some good reasons to use a
longer analysis time horizon
 Some out-year costs may be missed if the
time horizon is too short, e.g., a required
wastewater treatment plant upgrade in the
future
 Some annual operating costs may change
significantly over time, e.g., disposal fees at
landfills
 Short time horizons neglect the impact of the
time value of money, especially in times of
significant inflation, deflation, changing cost
74
of capital, etc.
Profitability assessment tips
Be sure to:
– Include all relevant and significant
costs/savings in the profitability analysis
– Think long-term (or at least mediumterm!)
– Incorporate the time value of money
– Use multiple profitability indicators
– Perform sensitivity analyses for data
estimates that are uncertain
75
Time for a break!
[15 min]
76
Sensitivity Analysis
[15 min]
77
Sensitivity Analysis
Introduction
An important management tool questioning
potential project benefit risks.
Assumptions surrounding a project are
computed to produce a base NPV and IRR.
From the base case, changes in the original
assumptions are made to gauge their effect on
the NPV and IRR.
Input variables varied adversely by 10%
78
Sensitivity Analysis
Example
Input Variables Varied by 10%
Original
Data
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Discount
Rate
Project Life
NPV
IRR
-2735000
-14978753
17122990
8022274
376354
8203865
76133
35%
5 years
7810
39%
10% increase 10% increase 10% decrease
in Cost of in Investment in cashflows
Capital
cost
-11323650
12951647
2592375
5151626
117364
374538
5142598
48,5%
-12456015
-14978753
17122990
8022274
376354
8203865
76133
35%
-2735000
-14828965
16951760
7942051
372590.5
8121826
75371.67
35%
5 years
5 years
-$2,741,092 -$8,940,009
54%
9%
5 years
$745,846
39%
79
Sensitivity Analysis
Summary
 Sensitivity Analysis permits project proposals
to be evaluated simply.
The model can evaluate sensitive variables
without having to input any additional data.
80
Sensitivity Analysis
Conclusion
•By amending the original data, a variable
whose change generates a negative NPV
and /or an IRR lower than the firm’s cost
of capital, is deemed to be sensitive.
•An investigation would need to be
undertaken for a contingent plan. If
results of the investigation are
unfavourable, the project is unacceptable
on economic grounds.
However, development projects with social
aspects may be treated differently.
81
Key
Profitability Indicators
[15 min]
82
Profitability indicators
We have seen so far:
• Simple Payback
• Net Present Value (NPV)
But there are others, common
examples are:
• Return on Investment (ROI)
• Internal Rate of Return (IRR)
83
Simple Payback and
Return on Investment (ROI)
These indicators incorporate:
– the initial investment cost
– the first year cash flow
Initial Investment
Simple Payback
=
(in years)
ROI (in %)
Year 1 Cash Flow
=
Year 1 Cash Flow
Initial Investment
84
How to interpret
Simple Payback and ROI
 The simple payback or ROI calculated
for a project are usually compared to
a company rule of thumb called a
“hurdle” rate:
– e.g., if the project payback period is less
than 3 years, then the project is viewed
as profitable
– e.g., if the ROI is 33%, then the project
is viewed as profitable
85
Net Present Value (NPV)
 NPV is a more reliable profitability
indicator than Simple Payback or ROI
as it considers both the time value of
money and all future year cash flows
 NPV = the sum of the discounted cash
flows over the lifetime of the project,
using the company’s cost of capital as
the discount rate
86
Internal Rate of Return (IRR)
 IRR is similar to NPV in that it
considers both the time value of
money and all future year cash flows
 IRR = the discount rate for which
NPV = 0, over the project lifetime
(calculated in an iterative fashion)
 It tells you exactly what “discount
rate” makes the project just barely
profitable
87
Profitability indicator summary
(1)
Simple
Payback
&
ROI
NPV
IRR
Advantage
Disadvantage
Easy to use
Neglect TVM
Neglect out-year costs
Do not indicate project size
Considers TVM
Indicates project size
Needs firm’s discount rate
Considers TVM
Requires iteration
Does not indicate project size
88
Profitability indicator summary
(2)
 NPV is generally the most valuable,
problem-free indicator
 Other indicators that consider the time
value of money (e.g., IRR) are also
useful
 Payback and ROI are easy to understand
and use, but of limited accuracy
 However, Simple Payback is particularly
useful with uncertain or risky investment
89
climates
Interpret profitability
indicators with caution...
 We have seen that Simple Payback has
some limitations as a project
profitability indicator
 Be aware of the advantages and
limitations of the indicators you use
 The best approach is to use several
indicators to give a balanced view of
project profitability
90
Other Profitability
Assessment Issues
[15 min]
91
Other issues
 There are other issues that impact a
project’s profitability, which we do
not have time to address today
– Source and cost of project financing
– Can you think of others?
92
Project financing
 Different sources of project financing
may have differing impacts on project
profitability
 Be sure to take financing payments
such as lease payments or payments
on loan principal and interest into
account appropriately when estimating
profitability
93
Project Profitability Assessment
Summary and Q&A
[15 min]
94
Project profitability
assessment
 Capital budgeting (of “environmental”
projects)
 Project cash flows and simple payback
 The Time Value of Money and Net
Present Value (NPV)
 Two small group exercises
 Capital budgeting : inflation and tax
 Sensitivity analysis
 Key profitability indicators
95