Business Case Development

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This presentation provides an overview of the basic principles and calculations often used in developing a financial justication analysis as part of a Business Case. Topics covered include:
- 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 the Business Case

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  • What a great presentation ! It is very easy to follow and covers very important points. Would you be so kind to share a copy ? It would be very much appreciated ! Thank you again, paul.folprecht@gmail.com
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  • excellent presentation, I would use some concepts in my business class. Gratefully if you can send this slides to anavav@gmail.com. thanks.
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  • It’s not all about the investment
  • Business Case Development

    1. 1. Business Case Development Core Professional Skills Training Document August, 2011
    2. 2. Agenda <ul><li>Introduction to Business Case Development </li></ul><ul><li>Financial Justification </li></ul><ul><ul><li>Terms and Metrics </li></ul></ul><ul><ul><ul><li>Pre-Tax Cash Flow </li></ul></ul></ul><ul><ul><ul><li>Payback Period </li></ul></ul></ul><ul><ul><ul><li>Accounting Terms and Principles </li></ul></ul></ul><ul><ul><ul><li>Depreciation Methods </li></ul></ul></ul><ul><ul><ul><li>After-Tax Cash Flow </li></ul></ul></ul><ul><ul><ul><li>Discounted Cash Flow </li></ul></ul></ul><ul><ul><ul><li>Net Present Value </li></ul></ul></ul><ul><ul><ul><li>Internal Rate of Return </li></ul></ul></ul><ul><ul><ul><li>Modified Internal Rate or Return </li></ul></ul></ul><ul><ul><ul><li>Economic Value Added </li></ul></ul></ul><ul><ul><li>Packaging a Business Case </li></ul></ul>Outline of Today’s Business Case Training Session:
    3. 3. Introduction to Business Case Development
    4. 4. What is the Purpose of a Business Case? <ul><li>The “3 Legs” of a Persuasive Argument </li></ul>The purpose of a business case approach is to present a persuasive argument for a recommended path forward. Credibility Logic Appeal
    5. 5. What is a Business Case? In its simplest form, a business case is about justifying the investment required by the potential value created. Value Created Investment Required Business Case =
    6. 6. Types of Investment? <ul><li>Example investments: </li></ul><ul><ul><li>Capital and Assets </li></ul></ul><ul><ul><ul><li>Systems </li></ul></ul></ul><ul><ul><ul><li>Equipment </li></ul></ul></ul><ul><ul><ul><li>Building </li></ul></ul></ul><ul><ul><ul><li>Inventory </li></ul></ul></ul><ul><ul><li>Expenses </li></ul></ul><ul><ul><ul><li>People </li></ul></ul></ul><ul><ul><ul><li>Supplies </li></ul></ul></ul><ul><ul><ul><li>Professional Fees </li></ul></ul></ul><ul><ul><ul><li>Travel Expenses </li></ul></ul></ul>An investment can be considered as any type of commitment necessary to create value, most of which can be translated to monetary terms. Impact the Balance Sheet Impact the Income Statement
    7. 7. What is Value? There are many ways to create value, all of which can be articulated in a business case. <ul><li>Revenue </li></ul><ul><li>Growth </li></ul><ul><li>Quality </li></ul><ul><li>Service </li></ul><ul><li>Flexibility </li></ul><ul><li>Risks </li></ul><ul><li>Time </li></ul><ul><li>Costs </li></ul><ul><li>Working Capital </li></ul><ul><li>Taxes </li></ul>Increase These Value = Decrease These
    8. 8. Financial Justification
    9. 9. Financial Justification Ideally, financial justification provides the “meaningful” monetary statistics necessary to drive a decision.
    10. 10. 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 Considerations 1. Specify the feasible alternatives <ul><li>What are we comparing against? </li></ul><ul><li>What is the cost of doing nothing? </li></ul>2. Determine the financial metrics to assess <ul><li>What financial metrics will be compared (e.g. NPV, IRR, MIRR, EVA, etc.)? </li></ul>3. Establish pre-tax cash flow estimates <ul><li>What are the positive and negative cash flows for each alternative </li></ul><ul><li>What is the timing of these cash flows? </li></ul><ul><li>What is the cash flow horizon? </li></ul>4. Use accounting view of cash flow and ROI (return on investment) <ul><li>How do we impact the income statement? </li></ul><ul><li>How do we impact the balance sheet? </li></ul>5. Determine depreciation expense <ul><li>What will be capitalized vs. expensed? </li></ul><ul><li>What depreciation method will be used? </li></ul><ul><li>What is the depreciation time period for each asset? </li></ul>6. Calculate after-tax cash flow <ul><li>What is the client income tax rate? </li></ul>7. Calculate discounted cash flow <ul><li>What rate will be used to determine the NPV of cash flows? </li></ul>8. Assess alternatives based on financial metrics <ul><li>How do the numbers stack up and compare? </li></ul><ul><li>Does the answer change is different assumptions are used? </li></ul>9. Perform qualitative analysis <ul><li>What other factors need to be considered beyond the ROI? </li></ul>10. Package the business case <ul><li>What is the level of detail needed to present your recommendation? </li></ul><ul><li>What questions must be answered to drive a decision? </li></ul>
    11. 11. 1. Define the Feasible Alternatives <ul><li>What are the alternatives? </li></ul><ul><ul><li>Are we offering just one alternative? </li></ul></ul><ul><ul><li>What is the cost of doing nothing? </li></ul></ul><ul><li>The “do nothing” alternative: </li></ul><ul><ul><li>The easiest alternative to do, but not always a practical </li></ul></ul><ul><ul><li>There is usually a cost of doing nothing </li></ul></ul><ul><ul><li>Compare the cost of doing nothing vs. feasible alternatives </li></ul></ul><ul><ul><li>Often, an alternative with a relatively low return can be justified when compared with doing nothing </li></ul></ul><ul><li>Comparing the recommended investment with multiple alternatives, including doing nothing, provides a perspective to aid in the decision making process </li></ul>The first step in justifying an investment is to define the feasible alternatives, including the possibility of doing nothing.
    12. 12. 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 project’s 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 company’s 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.
    13. 13. Financial Metric Considerations Net Cash Flow <ul><li>Simple, but does not consider time value of money </li></ul><ul><li>Overstates the relative value of longer term cash flow </li></ul>Simple ROI <ul><li>Simple, but does not consider time value of money </li></ul><ul><li>Difficult to compare alternative investments without also knowing size of cash flow </li></ul>Simple Payback <ul><li>Conceptually easy to understand </li></ul><ul><li>Measures relative risk of projects (i.e. short payback = lower risk) </li></ul><ul><li>Simple, but does not consider time value of money </li></ul><ul><li>Does not consider positive cash flow after breakeven </li></ul>Discount Rate <ul><li>Generally difficult to determine what rate to use </li></ul><ul><li>Perform sensitivity analysis using discount rates </li></ul>Discounted Payback <ul><li>More acceptable version of payback </li></ul><ul><li>But, does not consider positive cash flow after breakeven </li></ul>Discounted Cash Flow (DCF) <ul><li>Most acceptable method of evaluating cash flows </li></ul><ul><li>Perform sensitivity analysis of different discount rates and time horizons </li></ul>Net Present Value (NPV) <ul><li>Result of discount cash flow analysis </li></ul><ul><li>Positive NPV represents a favorable project </li></ul><ul><li>Pursue the project alternative with the highest NPV </li></ul>Internal Rate of Return (IRR) <ul><li>Often compared against desired “hurdle rates”, which are generally higher than the cost of capital </li></ul><ul><li>Pursue project alternative that exceed internal hurdle rate </li></ul><ul><li>Incorrectly assumes positive cash flow can be reinvested at IRR </li></ul>Modified IRR (MIRR) <ul><li>Assumes positive cash flows are reinvested at avg. company rate of return </li></ul><ul><li>Generates more conservative and realistic expected rate of return </li></ul>Economic Value Added (EVA) <ul><li>Evaluates project return against the cost of capital investment </li></ul><ul><li>Generally, more difficult to calculate correctly without Accountant oversight </li></ul>
    14. 14. 3. Establish Pre-Tax Cash Flow Estimates <ul><li>What are the value levers impacted by the investment? Examples: </li></ul><ul><ul><li>Costs </li></ul></ul><ul><ul><li>Revenue </li></ul></ul><ul><ul><li>Working Capital </li></ul></ul><ul><li>What is the incremental cash flow for each value lever? </li></ul><ul><li>When will these savings begin? </li></ul><ul><li>What are the costs associated with the investment </li></ul><ul><ul><li>One time </li></ul></ul><ul><ul><li>Ongoing </li></ul></ul>The core component of a financial justification is the anticipated positive and negatives cash flow associated with the investment. Pre-tax cash flow analysis allows for “quick and dirty” calculations such as Simple ROI and Simple Payback.
    15. 15. Net Cash Flow - Project A <ul><li>The net cash flow is a positive $300. </li></ul>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) 0 1 2 3 4 5 Total Cash Inflow $0 $0 $150 $150 $150 $150 $600 Cash Outflows ($200) ($100) $0 $0 $0 $0 ($300) Net Cash Flow ($200) ($100) $150 $150 $150 $150 $300
    16. 16. Net Cash Flow - Project B <ul><li>The net cash flow is a positive $1,000. </li></ul>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) 0 1 2 3 4 5 6 7 Total Cash Inflow $0 $0 $250 $250 $250 $250 $250 $250 $1,500 Cash Outflows ($400) ($100) $0 $0 $0 $0 $0 $0 ($500) Net Cash Flow ($400) ($100) $250 $250 $250 $250 $250 $250 $1,000
    17. 17. Net Cash Flow and Simple ROI - Project A <ul><li>Simple ROI is the ratio of net cash flow divided by the initial investment. </li></ul>One way to evaluate the net cash flow is through a “Simple ROI” calculation. Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 Total Cash Inflow $0 $0 $150 $150 $150 $150 $600 Cash Outflows ($200) ($100) $0 $0 $0 $0 ($300) Net Cash Flow ($200) ($100) $150 $150 $150 $150 $300 Net Cash Flow $300 Total Investment ($300) Simple ROI 100%
    18. 18. Net Cash Flow and Simple ROI - Project B <ul><li>Simple ROI is the ratio of net cash flow divided by the initial investment. </li></ul>One way to evaluate the net cash flow is through a “Simple ROI” calculation. Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 6 7 Total Cash Inflow $0 $0 $250 $250 $250 $250 $250 $250 $1,500 Cash Outflows ($400) ($100) $0 $0 $0 $0 $0 $0 ($500) Net Cash Flow ($400) ($100) $250 $250 $250 $250 $250 $250 $1,000 Net Cash Flow $1,000 Total Investment ($500) Simple ROI 200%
    19. 19. Simple Payback - Project A <ul><li>Simply payback is the period of time, usually measured in years, required to recover the original project investment. </li></ul>Simple Payback is perhaps the most popular “quick and dirty” method of evaluating a potential investment. 3.0 Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 Total Cumulative Cash Flow ($200) ($300) ($150) $0 $150 $300 $600 Payback Years 3
    20. 20. Simple Payback - Project B <ul><li>Simply payback is the period of time, usually measured in years, required to recover the original project investment. </li></ul>Simple Payback is perhaps the most popular “quick and dirty” method of evaluating a potential investment. Using payback period as the criteria, project A and B are equal. 3.0 Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 6 7 Total Cumulative Cash Flow ($400) ($500) ($250) $0 $250 $500 $750 $1,000 $1,000 Payback Years 3
    21. 21. Time Horizon Considerations - Example 1 Generally, the longer the cash flow horizon the higher the return. Example of 5 vs. 7 Year Horizon: (5 Year Horizon) (7 Year Horizon) NPV = $141 NPV = $303
    22. 22. Time Horizon Considerations - Example 2 Anticipated Cash Flow $1.0 M annual savings $2.0 M Initial Investment (Discount Rate = 10%) 3 Year Horizon 0 1 2 3 The time horizon assumed for the ROI analysis can have a significant impact on whether an investment is deemed favorable or not. $1.0 M annual savings $2.0 M Initial Investment (Discount Rate = 10%) 6 Year Horizon 0 1 2 3 4 5 6 Net Cash Flow Simple ROI Payback NPV IRR MIRR $1.0 M 50% 2 $0.49 M 23% 18% $4.0 M 200% 2 $2.36 M 45% 25%
    23. 23. Time Horizon Considerations - Example 3 6 Year Horizon $2.0 M annually savings $5.0 M initial investment (Discount Rate = 10%) 0 1 2 3 4 5 6 Anticipated Cash Flow The time horizon assumed for the ROI analysis can have a significant impact on whether an investment is deemed favorable or not. Net Cash Flow Simple ROI Payback NPV IRR MIRR $1.0 M 20% 2.5 ($0.03) M 10% 10% $7.0 M 140% 2.5 $3.71 M 33% 21% 3 Year Horizon $2.0M annually savings $5.0 M initial investment (Discount Rate = 10%) 0 1 2 3
    24. 24. Net Cash Flow - Words of Wisdom Set practical expectations on cash flow estimates. OVERAMBITIOUS Your Ambition Is Noteworthy But Not Very Practical
    25. 25. 4. Use Accounting View of Cash Flow & ROI Increase Net Income Increase Revenues Decrease COGS Reduce Selling Costs Reduce Distribution Costs Reduce Admin. Costs Increase Gross Profit Reduce Operating Expenses Reduce Net Capital Increase Net Operating Profit Before Taxes Reduce Capital Charges Increase Return on Investment Reduce % Cost of Capital Reduce Working Capital Reduce Fixed Assets Depreciation Reduce Income Taxes Reduce Interest Expense Costs & Revenues Assets & Liabilities A cash flow and ROI analysis must be put into accounting terms.
    26. 26. Income Statement - Example The income statement represents the overall revenue, costs, and profit of the organization. Income Statement (000’s) Revenue $2,000 Cost of Good Sold (COGS) ($1,000) Gross Income $1,000 Gross Margin 50% Operating Expenses (SG&A)* ($400) Selling, general, and administrative costs EBITDA $600 Earnings before interest, taxes, depreciation and amortization *Depreciation ($200) Non Cash Expense (*often embedded in SG&A) Operating Income $400 Operating Margin 20% Other Non-Operating Expenses ($20) Other Non Operating Revenue $40 EBIT $420 Earnings before interest and taxes Interest Expense ($50) Net Profit Before Taxes $370 Taxes ($148) Net Income $222 Note that Net Income is not equivalent to Net After Tax Cash Flow Profit Margin 11%
    27. 27. Balance Sheet - Example A balance sheet states a company’s assets, liabilities (debt) and equity (net worth), where Assets = Liabilities + Equity. Example: What balance sheet line items do we typically impact? Assets (000’s) Cash $ 42 Securities $ 28 Accounts Receivable $ 166 Inventory $ 490 Prepaid Expenses $ 16 Other Current Assets $ 33 Total Current Assets $ 775 Long Term Investments $ 87 Property, Plant & Equipment $ 760 Less Accumulated Appreciation Intangible Assets $ 100 Other Assets $ - Total Assets $ 1,722 Liabilities Short Term Debt $ 50 Accounts Payable $ 198 Accrued Expenses $ 10 Other Payables $ 63 Current Portion of Long Term Debt $ - Total Current Liabilities $ 321 Long Term Debt $ 500 Total Liabilities $ 821 Equity Capital Stock $ 700 Additional Paid in Capital $ 37 Retained Earnings $ 164 Total Equity $ 901 Total Debt & Equity $ 1,722
    28. 28. Financial Ratios Common financial ratios used in evaluating the financial health of an organization. Liquidity - Ability to meet short term obligations 2.4 Current Ratio = Current Assets/Current Liabilities 0.9 Quick (Acid Test) Ratio = (Current Assets - Inventory)/Current Liabilities 0.2 Cash Ratio = (Cash + Marketable Securities)/Current Liabilities $454.0 Working Capital = Current Assets – Current Liabilities Activity - Ability to effectively utilize assets 7.7 Days of Cash = Cash/(Sales/365) 30.3 Average Collection Period (in days) = Accounts Receivable/(Sales/365) 178.9 Days of Inventory = Inventory/(COGS/365) 12.0 Receivables Turnover = Sales/Receivables 2.0 Inventory Turns = COGS/Inventory 1.2 Asset Turnover = Sales/Total Assets Profitability - Ability to generate profit 11.1% Net Profit Margin = Net Income/Sales 50.0% Gross Profit Margin = (Sales - COGS)/Sales 20.0% Operating Profit Margin = (Sales - COGS - SGA)/Sales 12.9% Return on Assets = Net Income/Total Assets = Net Profit Margin x Asset Turnover 30.1% Return on Equity = Net Income/Total Equity 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
    29. 29. After Tax Cash Flow - Example <ul><li>Depreciation expense reduces tax liability </li></ul><ul><li>Generally, it is included as part of operating expenses </li></ul><ul><li>However, it is a non-cash based expense </li></ul><ul><li>Therefore, depreciation is added back to net profit after taxes </li></ul>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) <ul><li>Depreciation </li></ul>($200) Net Profit Before Taxes $370 - Taxes ($148) Net Profit After Taxes $222 + Depreciation (add back) $200 = Net After-Tax Cash Flow $422
    30. 30. 5. Determine Depreciation Expense <ul><li>Tangible operational assets, except land, are subject to depreciation because they have limited economic lives. </li></ul><ul><li>Depreciation begins the period when the asset is placed into service for it’s intended use </li></ul><ul><li>Depreciation is a non-cash expense that reduces the asset’s book value and a company’s tax liability </li></ul><ul><li>Depreciation for each asset is usually calculated separately and is based on four factors: </li></ul><ul><ul><li>Acquisition cost; </li></ul></ul><ul><ul><li>Estimated life; </li></ul></ul><ul><ul><li>Residual (or salvage) value (book value after being fully depreciated); </li></ul></ul><ul><ul><li>Method of depreciation selected. </li></ul></ul><ul><li>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. </li></ul><ul><li>Estimated life is the number of years a company expects the asset to last or the amount of measurable production it expects from asset. </li></ul><ul><li>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 </li></ul><ul><li>Several potential depreciation methods may be used (to be further discussed) </li></ul>General considerations when determining depreciation:
    31. 31. Depreciation of Capital Expenditures <ul><li>Capital expenditures (CAPEX) are expenditures creating future benefits. </li></ul><ul><li>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. </li></ul><ul><li>The general rule is that if the property acquired has a useful life longer than the taxable year, the cost must be capitalized. </li></ul><ul><li>The CAPEX costs are then amortized or depreciated over the life of the asset. </li></ul><ul><li>For accounting purposes, a CAPEX is added to an asset account (e.g. Property, Plant, and Equipment), and the asset’s book value is decreased annually by the amount of accumulated depreciation. </li></ul><ul><li>For tax purposes, CAPEX are costs that cannot be deducted in the year in which they are paid or incurred , and must be capitalized. </li></ul><ul><li>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. </li></ul>Capital expenditures (CAPEX) form the basis of the assets being depreciated.
    32. 32. Depreciation – Acquisition Cost <ul><li>Example: </li></ul><ul><li>Consideration for Consulting Fees: Typically, they are: </li></ul><ul><ul><li>Included if they are engaged in detail design, development, and installation of the asset </li></ul></ul><ul><ul><li>Excluded if they are engaged in process design, selection, training, and operations transition </li></ul></ul>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. Invoice price, gross $ 150,000 Less: 20% discount $ (30,000) Invoice price, net $ 120,000 State sales tax @ 5% $ 6,000 Transportation costs $ 4,000 Installation costs $ 10,000 Total Acquisition Cost $ 140,000
    33. 33. <ul><li>Generally Accepted Accounting Principles (GAAP) is the standard framework of guidelines for financial reporting </li></ul><ul><li>GAAP Methods for Depreciation </li></ul><ul><ul><li>Straight Line </li></ul></ul><ul><ul><li>Productive Output </li></ul></ul><ul><ul><li>Declining Balance </li></ul></ul><ul><ul><li>Sum of the Years Digits </li></ul></ul><ul><li>The depreciation period is based on it’s estimated useful file or units </li></ul><ul><li>Modified Accelerated Cost Recovery System (MACRS) is the current method of accelerated asset depreciation required by the United States income tax code. </li></ul><ul><li>Specific types of assets are assigned to X-year property classes with distinct accelerated depreciation schedules. </li></ul><ul><li>MACRS is required by the IRS for tax reporting but is not approved by GAAP for external reporting. </li></ul>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 Tax Reporting Methods
    34. 34. Depreciation – Straight Line Depreciation <ul><li>Depreciation = (Cost - Salvage value) / Useful life </li></ul><ul><li>Example: </li></ul><ul><ul><li>Acquisition Cost $140,000 </li></ul></ul><ul><ul><li>Salvage Value $20,000 </li></ul></ul><ul><ul><li>Depreciable Value $120,000 </li></ul></ul><ul><ul><li>Useful Life 5 Years </li></ul></ul><ul><ul><li>Depreciation/Year $120,000/5 = $24,000 </li></ul></ul><ul><li>The MS Excel Function is SLN(cost,salvage,life), where </li></ul><ul><ul><li>Cost is the initial cost of the asset. </li></ul></ul><ul><ul><li>Salvage is the value at the end of the depreciation (sometimes called the residual value of the asset). </li></ul></ul><ul><ul><li>Life is the number of periods over which the asset is depreciated (sometimes called the useful life of the asset). </li></ul></ul>Straight line depreciation is the easiest to determine.
    35. 35. Depreciation – Straight Line Depreciation <ul><li>Example: </li></ul><ul><ul><li>Acquisition Cost $140,000 </li></ul></ul><ul><ul><li>Salvage Value $20,000 </li></ul></ul><ul><ul><li>Depreciable Value $120,000 </li></ul></ul><ul><ul><li>Useful Life 5 Years </li></ul></ul>Example of Straight Line Depreciation: *Example assumes asset is placed into service at end of year 0. Year 0 1 2 3 4 5 Depreciation Percentage   20% 20% 20% 20% 20% Depreciable Base for Calculation $120,000 $120,000 $120,000 $120,000 $120,000 $120,000 Depreciation Expense $ - $ 24,000 $ 24,000 $ 24,000 $ 24,000 $ 24,000 Cumulative Depreciation $ - $ 24,000 $ 48,000 $ 72,000 $ 96,000 $120,000 Beginning Book Value $140,000 $140,000 $116,000 $ 92,000 $ 68,000 $ 44,000 Ending Book Value $140,000 $116,000 $ 92,000 $ 68,000 $ 44,000 $ 20,000
    36. 36. Depreciation – Straight Line vs. Accelerated <ul><li>Cost = $140,000, Salvage Value = $20,000, and Useful Life = 5 Years </li></ul>Accelerated depreciation methods are commonly used because they reduce a company’s tax burden during the initial years following installation more so than the straight line method. Example: *Example assumes asset is placed into service at end of year 0. Financial Analysis Useful Life (Years) 0 1 2 3 4 5 Total Cash Inflow $0 $80,000 $80,000 $80,000 $80,000 $80,000 $400,000 Cash Outflows ($140,000) $0 $0 $0 $0 $0 ($140,000) Net Cash Flow (Pre-Tax) ($140,000) $80,000 $80,000 $80,000 $80,000 $80,000 $260,000 Straight Line Depreciation Depreciation (Straight Line) $0 ($24,000) ($24,000) ($24,000) ($24,000) ($24,000) ($120,000) Net Operating Profit (Before Tax) $0 $56,000 $56,000 $56,000 $56,000 $56,000 $140,000 Taxes (40%) $0 ($22,400) ($22,400) ($22,400) ($22,400) ($22,400) ($112,000) Accelerated Depreciation (Sum of Years Digits) Depreciation (Accelerated) $0 ($40,000) ($32,000) ($24,000) ($16,000) ($8,000) ($120,000) Net Operating Profit (Before Tax) $0 $40,000 $48,000 $56,000 $64,000 $72,000 $140,000 Taxes (40%) $0 ($16,000) ($19,200) ($22,400) ($25,600) ($28,800) ($112,000)
    37. 37. Depreciation – Sum of the Years Digits <ul><li>Depreciation = [Useful Life – (Current Period– 1)]/SYD * Depreciable Value, Where SYD = Useful Life*[(Useful Life+1)/2] </li></ul><ul><li>Example </li></ul><ul><ul><li>Acquisition Cost $140,000 </li></ul></ul><ul><ul><li>Salvage Value $20,000 </li></ul></ul><ul><ul><li>Depreciable Value $120,000 </li></ul></ul><ul><ul><li>Useful Life 5 Years </li></ul></ul><ul><ul><li>Current Period 3 rd Year </li></ul></ul><ul><ul><li>SYD = 5*[(5+1)/2] = 15, or 1+2+3+4+5 = 15 </li></ul></ul><ul><ul><li>Depreciation = [5-(3-1)]/15*$120,000 = $24,000 </li></ul></ul><ul><li>The MS Excel Function is SYD(cost,salvage,life,per), where Per is the period being depreciated </li></ul>Sum of the years digits is an accelerated depreciation method with a decreasing percentage of depreciation applied each year.
    38. 38. Depreciation – Sum of the Years Digits <ul><li>Example </li></ul><ul><ul><li>Acquisition Cost $140,000 </li></ul></ul><ul><ul><li>Salvage Value $20,000 </li></ul></ul><ul><ul><li>Depreciable Value $120,000 </li></ul></ul><ul><ul><li>Useful Life 5 Years </li></ul></ul>Example of Sum of the Years Depreciation: *Example assumes asset is placed into service at end of year 0. Year 0 1 2 3 4 5 Depreciation Percentage   33% 27% 20% 13% 7% Depreciable Base for Calculation $120,000 $120,000 $120,000 $120,000 $120,000 $120,000 Depreciation Expense $ - $ 40,000 $ 32,000 $ 24,000 $ 16,000 $ 8,000 Cumulative Depreciation $ - $ 40,000 $ 72,000 $ 96,000 $112,000 $120,000 Beginning Book Value $140,000 $140,000 $100,000 $ 68,000 $ 44,000 $ 28,000 Ending Book Value $140,000 $100,000 $ 68,000 $ 44,000 $ 28,000 $ 20,000
    39. 39. Depreciation – Fixed Declining Balance <ul><li>Depreciation =[1-((Salvage Value/Cost)^(1/Life))]*Book Value, </li></ul><ul><ul><li>Where Book Value = Acquisition Cost – Accumulated Depreciation </li></ul></ul><ul><li>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. </li></ul><ul><li>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 zero-dollar salvage value will be fully depreciated in the first period. </li></ul>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.
    40. 40. Depreciation – Fixed Declining Balance <ul><li>Example: </li></ul><ul><ul><li>Acquisition Cost $140,000 (equals initial book value) </li></ul></ul><ul><ul><li>Salvage Value $20,000 ( must be >=10% of cost ) </li></ul></ul><ul><ul><li>Useful Life 5 Years </li></ul></ul>Example of Fixed Declining Balance Depreciation. This method is not recommended. *Example assumes asset is placed into service at end of year 0. Year 0 1 2 3 4 5 Depreciation Percentage   32% 32% 32% 32% 32% Depreciable Base for Calculation $140,000 $140,000 $ 94,920 $ 64,356 $ 43,633 $ 29,583 Depreciation Expense $ - $ 45,080 $ 30,564 $ 20,723 $ 14,050 $ 9,583 Cumulative Depreciation $ - $ 45,080 $ 75,644 $ 96,367 $110,417 $120,000 Beginning Book Value $140,000 $140,000 $ 94,920 $ 64,356 $ 43,633 $ 29,583 Ending Book Value $140,000 $ 94,920 $ 64,356 $ 43,633 $ 29,583 $ 20,000
    41. 41. Depreciation – Double Declining Balance <ul><li>Depreciation =(1/Life* 2 )*Book Value, </li></ul><ul><li>Where Book Value = Acquisition Cost – Accumulated Depreciation </li></ul><ul><li>Example: </li></ul><ul><ul><li>Acquisition Cost $140,000 (equals initial book value) </li></ul></ul><ul><ul><li>Salvage Value $20,000 </li></ul></ul><ul><ul><li>Useful Life 5 Years </li></ul></ul><ul><ul><li>Current Period 3 rd Year </li></ul></ul><ul><ul><li>Depreciation Factor = (1/5*2) = 40% </li></ul></ul><ul><ul><li>Depreciation 1 st Year = 40% * $140,000 = $56,000 </li></ul></ul><ul><ul><li>Depreciation 2 nd Year = 40% * ($140,000 - $56,000) = $33,600 </li></ul></ul><ul><ul><li>Depreciation 3 nd Year = 40% * ($140,000 - $89,600) = $20,160 </li></ul></ul>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.
    42. 42. Depreciation – Double Declining Balance <ul><li>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 double-declining balance method). </li></ul><ul><li>Unfortunately, the MS Excel function does not fully depreciate the entire balance if the salvage value of the asset is low compared to it’s acquisition cost. </li></ul><ul><li>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. </li></ul><ul><li>Fortunately, the MS Excel “VDB” function will correctly calculate the depreciation for each year </li></ul><ul><li>VDB(cost,salvage,life,start_period,end_period,factor,no_switch), where: </li></ul><ul><ul><li>Start_period is the starting period for which you want to calculate the depreciation. </li></ul></ul><ul><ul><li>End_period is the ending period for which you want to calculate the depreciation. </li></ul></ul><ul><ul><li>Factor is the rate at which the balance declines. If factor is omitted, it is assumed to be 2 (the double-declining balance method). </li></ul></ul><ul><ul><li>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. </li></ul></ul>The MS Excel “VDB” function rather than the “DDB” function should be used to calculate double declining depreciation.
    43. 43. Depreciation – Double Declining Balance <ul><li>Example: </li></ul><ul><ul><li>Acquisition Cost $140,000 (equals initial book value) </li></ul></ul><ul><ul><li>Salvage Value $20,000 </li></ul></ul><ul><ul><li>Useful Life 5 Years </li></ul></ul><ul><li>VDB(cost,salvage,life,start_period,end_period, 2 , False ), </li></ul>Example of Double Declining Balance Depreciation: *Example assumes asset is placed into service at end of year 0. Year 0 1 2 3 4 5 Depreciation Percentage   40% 40% 40% 34% 0% Depreciable Base for Calculation $140,000 $140,000 $ 84,000 $ 50,400 $ 30,240 $ 20,000 Depreciation Expense $ - $ 56,000 $ 33,600 $ 20,160 $ 10,240 $ - Cumulative Depreciation $ - $ 56,000 $ 89,600 $109,760 $120,000 $120,000 Beginning Book Value $140,000 $140,000 $ 84,000 $ 50,400 $ 30,240 $ 20,000 Ending Book Value $140,000 $ 84,000 $ 50,400 $ 30,240 $ 20,000 $ 20,000
    44. 44. Depreciation – 150% Declining Balance <ul><li>VDB(cost,salvage,life,start_period,end_period, 1.5 , False ), </li></ul><ul><li>Example: </li></ul><ul><ul><li>Acquisition Cost $140,000 (equals initial book value) </li></ul></ul><ul><ul><li>Salvage Value $20,000 </li></ul></ul><ul><ul><li>Useful Life 5 Years </li></ul></ul>Variations of declining balance may be used. The following is an example of 150% Declining Balance Depreciation: *Example assumes asset is placed into service at end of year 0. Year 0 1 2 3 4 5 Depreciation Percentage   30% 30% 30% 30% 41% Depreciable Base for Calculation $140,000 $140,000 $ 98,000 $ 68,600 $ 48,020 $ 33,614 Depreciation Expense $ - $ 42,000 $ 29,400 $ 20,580 $ 14,406 $ 13,614 Cumulative Depreciation $ - $ 42,000 $ 71,400 $ 91,980 $106,386 $120,000 Beginning Book Value $140,000 $140,000 $ 98,000 $ 68,600 $ 48,020 $ 33,614 Ending Book Value $140,000 $ 98,000 $ 68,600 $ 48,020 $ 33,614 $ 20,000
    45. 45. Depreciation – Productive Output <ul><li>Depreciation = (Cost - Salvage value) * (Actual Units Produced/Lifetime Units Expected) </li></ul><ul><li>Example: </li></ul><ul><ul><li>Acquisition Cost $140,000 </li></ul></ul><ul><ul><li>Salvage Value $20,000 </li></ul></ul><ul><ul><li>Depreciable Value $120,000 </li></ul></ul><ul><ul><li>Lifetime Units 100,000 </li></ul></ul><ul><ul><li>Depreciable $/Unit $1.20 </li></ul></ul>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. Year 1 2 3 4 5 Productive Output 15,000 25,000 25,000 20,000 15,000 Depreciation Percentage 15% 25% 25% 20% 15% Depreciation Expense $ 18,000 $ 30,000 $ 30,000 $ 24,000 $ 18,000
    46. 46. Depreciation – Productive Output <ul><li>Example: </li></ul><ul><ul><li>Acquisition Cost $140,000 </li></ul></ul><ul><ul><li>Salvage Value $20,000 </li></ul></ul><ul><ul><li>Depreciable Value $120,000 </li></ul></ul><ul><ul><li>Lifetime Units 100,000 </li></ul></ul><ul><ul><li>Depreciable $/Unit $1.20 </li></ul></ul>Example of Productive Output Depreciation: *Example assumes asset is placed into service at end of year 0. Year 0 1 2 3 4 5 Productive Output   15,000 25,000 25,000 20,000 15,000 Depreciation Percentage   15% 25% 25% 20% 15% Depreciable Base for Calculation $120,000 $120,000 $120,000 $120,000 $120,000 $120,000 Depreciation Expense $ - $ 18,000 $ 30,000 $ 30,000 $ 24,000 $ 18,000 Cumulative Depreciation $ - $ 18,000 $ 48,000 $ 78,000 $102,000 $120,000 Beginning Book Value $140,000 $140,000 $122,000 $ 92,000 $ 62,000 $ 38,000 Ending Book Value $140,000 $122,000 $ 92,000 $ 62,000 $ 38,000 $ 20,000
    47. 47. 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 asset’s useful life. Illustration
    48. 48. Depreciation - MACRS <ul><li>Assets are grouped into property classes </li></ul><ul><li>The depreciation is predetermined by the MACRS table for each property class </li></ul><ul><li>The two most common asset classes besides real estate are the five-year and the seven-year asset class. </li></ul><ul><ul><li>The five-year asset class includes information systems, computers, and vehicles </li></ul></ul><ul><ul><li>The seven-year class includes most machinery and equipment </li></ul></ul><ul><li>Residual value is ignored </li></ul><ul><li>All fixed assets are assumed to be put in and taken out of service in the middle of the year. Therefore: </li></ul><ul><ul><ul><li>For the five-year class assets, depreciation is spread over six years. </li></ul></ul></ul><ul><ul><ul><li>For seven-year class assets, depreciation is spread over eight years. </li></ul></ul></ul><ul><ul><ul><li>The useful life is 39 years for nonresidential real property. Depreciation is straight line using the mid-month convention. </li></ul></ul></ul><ul><li>It is arguable as to whether a company may use the MACRS method for both financial statement and tax purposes </li></ul><ul><li>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. </li></ul>Modified Accelerated Cost Recovery System (MACRS) is the current method of accelerated asset depreciation required by the United States income tax code.
    49. 49. Depreciation – MACRS Table <ul><li>A half-year depreciation is allowed in the first and last recovery years. </li></ul><ul><li>Depreciation rates: </li></ul><ul><ul><li>The 3, 5, 7, and 10-year classes begin with double declining balance depreciation </li></ul></ul><ul><ul><li>15- and 20-year classes begin with 150% declining balance depreciation. </li></ul></ul><ul><ul><li>All classes convert to straight-line depreciation in the year highlighted </li></ul></ul>The table below represents the required depreciation for taxes purposes based on asset property class.* *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). % by Year by Property Class Recovery Year 3 5 7 10 15 20 1 33.33% 20.00% 14.29% 10.00% 5.00% 3.75% 2 44.45% 32.00% 24.49% 18.00% 9.50% 7.22% 3 14.81% 19.20% 17.49% 14.40% 8.55% 6.68% 4 7.41% 11.52% 12.49% 11.52% 7.70% 6.18% 5   11.52% 8.93% 9.22% 6.93% 5.71% 6   5.76% 8.92% 7.37% 6.23% 5.29% 7     8.93% 6.55% 5.90% 4.89% 8     4.46% 6.55% 5.90% 4.52% 9       6.56% 5.91% 4.46% 10       6.55% 5.90% 4.46% 11       3.28% 5.91% 4.46% 12         5.90% 4.46% 13         5.91% 4.46% 14         5.90% 4.46% 15         5.91% 4.46% 16         2.95% 4.46% 17           4.46% 18           4.46% 19           4.46% 20           4.46% 21           2.23%
    50. 50. Depreciation - MACRS <ul><li>Example: </li></ul><ul><ul><li>Acquisition Cost $140,000 (equals initial book value) </li></ul></ul><ul><ul><li>Salvage Value $20,000 ( not used in MACRS calculation ) </li></ul></ul><ul><ul><li>Property Class 5 Years </li></ul></ul>Example of MACRS Depreciation: *Example assumes asset is placed into service at any point in year 1. Year 1 2 3 4 5 6 Depreciation Percentage 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% Depreciable Base for Calculation $140,000 $140,000 $140,000 $140,000 $140,000 $140,000 Depreciation Expense $ 28,000 $ 44,800 $ 26,880 $ 16,128 $ 16,128 $ 8,064 Cumulative Depreciation $ 28,000 $ 72,800 $ 99,680 $115,808 $131,936 $140,000 Beginning Book Value $140,000 $112,000 $ 67,200 $ 40,320 $ 24,192 $ 8,064 Ending Book Value $112,000 $ 67,200 $ 40,320 $ 24,192 $ 8,064 $ -
    51. 51. 6. Calculate After Tax Cash Flow <ul><li>First, estimate pre-tax cash flows for each year of the investment life span </li></ul><ul><ul><li>Outflow (e.g. one time capital and expenses) </li></ul></ul><ul><ul><li>Inflow (e.g. net annual savings) </li></ul></ul><ul><li>Determine the annual depreciation on the capital investment </li></ul><ul><li>Subtract the annual depreciation from the pre-tax cash flow to determine the taxable net income (Net Operating Profit before Taxes) </li></ul><ul><li>Calculate the tax expense (for non-capital spending). The result is the Net Operating Profit after Taxes (NOPAT) </li></ul><ul><li>Subtract the tax expense from the pre-tax cash flows to arrive at the after tax cash flow. </li></ul>Basic steps to determine after tax cash flow:
    52. 52. Net Cash Flow After Taxes - Project A Investments must be evaluated on an after tax basis. *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. Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 Total Cash Inflow $0 $0 $150 $150 $150 $150 $600 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($200) ($100) $0 $0 $0 $0 ($300) Net Cash Flow (Pre-Tax) ($200) ($100) $150 $150 $150 $150 $300 Depreciation (5 Years) $0 ($40) ($40) ($40) ($40) ($40) ($200) Net Operating Profit (Before Tax) $0 ($140) $110 $110 $110 $110 $100 Taxes (40%) $0 $56 ($44) ($44) ($44) ($44) ($120) Net Cash Flow (After Tax) ($200) ($44) $106 $106 $106 $106 $180 Net Cash After Tax Flow $180 Total Investment ($300) Simple ROI (After-Tax Cash Flow) 60%
    53. 53. Net Cash Flow After Taxes - Project B Investments must be evaluated on an after tax basis. *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. Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 6 7 Total Cash Inflow $0 $0 $250 $250 $250 $250 $250 $250 $1,500 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($400) ($100) $0 $0 $0 $0 $0 $0 ($500) Net Cash Flow (Pre-Tax) ($400) ($100) $250 $250 $250 $250 $250 $250 $1,000 Depreciation (5 Years) $0 ($80) ($80) ($80) ($80) ($80) $0 $0 ($400) Net Operating Profit (Before Tax) $0 ($180) $170 $170 $170 $170 $250 $250 $600 Taxes (40%) $0 $72 ($68) ($68) ($68) ($68) ($100) ($100) ($400) Net Cash Flow (After Tax) ($400) ($28) $182 $182 $182 $182 $150 $150 $600 Net Cash After Tax Flow $600 Total Investment ($500) Simple ROI (After-Tax Cash Flow) 120%
    54. 54. 7. Calculate Discounted Cash Flow <ul><li>Money has a time value! </li></ul><ul><li>Time has a money value! </li></ul>Future Cash Flows (Factored by Discount Rate) = Preset Value of an Investment A discount rate is used to determine the present value of future cash flow. Discounted Cash Flow + + + +
    55. 55. Present Value and the Time Value of Money <ul><li>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). </li></ul><ul><li>Net Present Value = C 0 + C 1 + C 2 + C 3 … C N </li></ul><ul><li>1+r 1 1+r 2 1+r 3 … 1+r N </li></ul><ul><li>The higher the discount rate the lower the present value of future cash flow. </li></ul>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. 10% Discount Rate Financial Analysis Time Period (Years) 0 1 2 3 4 5 Total Future Cash Flow $100 $100 $100 $100 $100 $100 $600 Present Value (@10% discount rate) $100 $91 $83 $75 $68 $62 $479 Net Present Value $479 20% Discount Rate Financial Analysis Time Period (Years) 0 1 2 3 4 5 Total Future Cash Flow $100 $100 $100 $100 $100 $100 $600 Present Value (@20% discount rate) $100 $83 $69 $58 $48 $40 $399 Net Present Value $399
    56. 56. 8. Assess Alternatives Based on Financial Metrics <ul><li>Confirm basic cash flow assumptions </li></ul><ul><li>Confirm correctness of worksheet calculations </li></ul><ul><li>Conduct sensitivity analysis on key parameters. Examples: </li></ul><ul><ul><li>Discount rate </li></ul></ul><ul><ul><li>Time horizon </li></ul></ul><ul><ul><li>Magnitude of investment </li></ul></ul><ul><ul><li>Probabilities of annual savings realized </li></ul></ul><ul><ul><li>Probabilities operating costs required </li></ul></ul>The next step is calculate, assess, and compare the financial results of each defined alternative. Do a “sanity check” on the assumptions and the analysis before developing a presentation.
    57. 57. Results of Poor Financial Analysis MISCALCULATION Perhaps You Will Be Long Gone Before They Realize Your Mistake
    58. 58. Discounted Cash Flow and Net Present Value <ul><li>The higher the NPV the more favorable the investment. </li></ul>Net Present Value (NPV) is determined by simply discounting annual net cash flows by the assumed discount rate. *Also considered as the Present Value of after tax cash flow. Project A Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 Total Cash Inflow $0 $0 $150 $150 $150 $150 $600 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($200) ($100) $0 $0 $0 $0 ($300) Net Cash Flow (Pre-Tax) ($200) ($100) $150 $150 $150 $150 $300 Depreciation (5 Years) $0 ($40) ($40) ($40) ($40) ($40) ($200) Net Operating Profit (Before Tax) $0 ($140) $110 $110 $110 $110 $100 Taxes (40%) $0 $56 ($44) ($44) ($44) ($44) ($120) Net Cash Flow (After Tax) ($200) ($44) $106 $106 $106 $106 $180 Discounted Cash Flow* (using 10%) ($200) ($40) $88 $80 $72 $66 $65 Net Present Value $65
    59. 59. Discounted Cash Flow and Net Present Value <ul><li>The higher the NPV the more favorable the investment. </li></ul>Net Present Value (NPV) is determined by simply discounting annual net cash flows by the assumed discount rate. *Also considered as the Present Value of after tax cash flow. Project B Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 6 7 Total Cash Inflow $0 $0 $250 $250 $250 $250 $250 $250 $1,500 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($400) ($100) $0 $0 $0 $0 $0 $0 ($500) Net Cash Flow (Pre-Tax) ($400) ($100) $250 $250 $250 $250 $250 $250 $1,000 Depreciation (5 Years) $0 ($80) ($80) ($80) ($80) ($80) $0 $0 ($400) Net Operating Profit (Before Tax) $0 ($180) $170 $170 $170 $170 $250 $250 $600 Taxes (40%) $0 $72 ($68) ($68) ($68) ($68) ($100) ($100) ($400) Net Cash Flow (After Tax) ($400) ($28) $182 $182 $182 $182 $150 $150 $600 Discounted Cash Flow* (using 10%) ($400) ($25) $150 $137 $124 $113 $85 $77 $261 Net Present Value $261
    60. 60. Internal Rate of Return (IRR) <ul><li>IRR is the rate at which the investment has a Net Present Value of $0 </li></ul><ul><li>The lower the IRR the less favorable the investment. </li></ul><ul><li>IRR is often compared against a company’s threshold “hurdle rate” to determine whether the investment is worth pursuing. </li></ul>Internal Rate of Return (IRR) is often used in conjunction with or in lieu of an NPV analysis. 5% 10% 15% 20% 25% 30% NPV* IRR=18.7% Return Rate $300 ($300) $150 ($150) $0 NPV=$65 5% 10% 15% 20% 25% 30% NPV* IRR=24.4% Return Rate $300 ($300) $150 ($150) $0 NPV=$261 Project B Project A *The assumed discount rate used for projects is 10%
    61. 61. Modified Internal Rate of Return <ul><li>IRR is intuitively appealing but conceptually flawed. </li></ul><ul><ul><li>Intuitively, the higher the return the better the investment </li></ul></ul><ul><ul><li>And, IRR does not require an assumed discount rate (which is often difficult to agree on) </li></ul></ul><ul><ul><li>However, comparing alternative investments by IRR alone does not consider the total return or NPV of each investment </li></ul></ul><ul><ul><li>In addition, IRR assumes all positive cash flows can be reinvested at the IRR rate, which generally is a flawed assumption. </li></ul></ul><ul><li>Instead, a more appropriate approach is to assume positive cash flows can be reinvested at: </li></ul><ul><ul><li>The average rate of return of all company investments, or </li></ul></ul><ul><ul><li>The company cost of capital rate. </li></ul></ul><ul><li>This will result in a more conservative and realistic expected rate of return. </li></ul>The Modified IRR attempts to overcome the conceptual inaccuracies in the IRR calculation to determine a more realistic expected rate of return.
    62. 62. 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. The MIRR results in a more conservative and realistic expected rate of return Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 Total Cash Inflow $0 $0 $150 $150 $150 $150 $600 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($200) ($100) $0 $0 $0 $0 ($300) Net Cash Flow (Pre-Tax) ($200) ($100) $150 $150 $150 $150 $300 Depreciation (5 Years) $0 ($40) ($40) ($40) ($40) ($40) ($200) Net Operating Profit (Before Tax) $0 ($140) $110 $110 $110 $110 $100 Taxes (40%) $0 $56 ($44) ($44) ($44) ($44) ($120) Net Cash Flow (After Tax) ($200) ($44) $106 $106 $106 $106 $180 Discounted Cash Flow (using 10%) ($200) ($40) $88 $80 $72 $66 $65 Net Present Value $65 Internal Rate of Return (IRR) 18.7% Modified IRR (w/10% reinvestment rate) 15.1%
    63. 63. 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. The MIRR results in a more conservative and realistic expected rate of return Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 6 7 Total Cash Inflow $0 $0 $250 $250 $250 $250 $250 $250 $1,500 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($400) ($100) $0 $0 $0 $0 $0 $0 ($500) Net Cash Flow (Pre-Tax) ($400) ($100) $250 $250 $250 $250 $250 $250 $1,000 Depreciation (5 Years) $0 ($80) ($80) ($80) ($80) ($80) $0 $0 ($400) Net Operating Profit (Before Tax) $0 ($180) $170 $170 $170 $170 $250 $250 $600 Taxes (40%) $0 $72 ($68) ($68) ($68) ($68) ($100) ($100) ($400) Net Cash Flow (After Tax) ($400) ($28) $182 $182 $182 $182 $150 $150 $600 Discounted Cash Flow (using 10%) ($400) ($25) $150 $137 $124 $113 $85 $77 $261 Net Present Value $261 Internal Rate of Return (IRR) 24.4% Modified IRR (w/10% reinvestment rate) 17.7%
    64. 64. Example Financial Analysis <ul><li>$2,000 Marginal annual savings </li></ul><ul><li>$1,000 Marginal annual costs </li></ul><ul><li>$10,000 Inventory reduction </li></ul><ul><li>$9,000 Equipment investment </li></ul><ul><li>$2,000 Salvage value on equipment </li></ul><ul><li>$5,000 System investment with no salvage value </li></ul><ul><li>7 Years Equipment depreciation using sum of years digits (SYD) </li></ul><ul><li>5 Years System depreciation using sum of years digits (SYD) </li></ul><ul><li>7 Years Cash flow horizon </li></ul><ul><li>10% Discount rate </li></ul><ul><li>40% Tax rate </li></ul>Parameters for example ROI analysis:
    65. 65. Example Financial Analysis – ROI Inputs Example The input parameters are illustrated in the ROI template below:
    66. 66. Example Financial Analysis – Depreciation
    67. 67. Example Financial Analysis – ROI Outputs Example
    68. 68. Economic Value Added (EVA) <ul><li>EVA promotes the simple goal of generating more profit with the same or less capital requirement </li></ul><ul><li>EVA equals Net Operating Profit After Taxes (NOPAT) less the opportunity cost of capital </li></ul><ul><li>It compares the return on the investment vs. the average return on other investment opportunities </li></ul><ul><li>EVA must be positive to be considered a potential worthwhile investment </li></ul><ul><li>Calculation Terms: </li></ul><ul><ul><li>EVA = NOPAT – WACC * Invested Capital, where </li></ul></ul><ul><ul><li>NOPAT = Operating profit x (1 - Tax Rate) </li></ul></ul><ul><ul><li>WACC = weighted avg. cost of capital (discount rate of debt and equity) </li></ul></ul><ul><ul><li>Invested Capital = Annual net change in assets associated with investment </li></ul></ul>Economic Value Added (EVA) is another metric used to evaluate the return of a company or investment.
    69. 69. 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: Non-operating costs and revenues, and their proportional taxes, are excluded from NOPAT. Example Income Statement Revenue $2,000 Cost of Good Sold (COGS) ($1,000) Gross Income $1,000 Gross Margin 50% Operating Expenses (SG&A)* ($400) Selling, general, and administrative costs EBITDA $600 Earnings before interest, taxes, depreciation and amortization *Depreciation ($200) Non Cash Expense (*often embedded in SG&A) Operating Income $400 Also referred to as EBIT Operating Margin 20% Other Non-Operating Expenses ($20) Other Non-Operating Revenue $40 EBIT $420 Earnings before interest and taxes Interest Expense ($50) Net Profit Before Taxes $370 Taxes (40%) $148 Net Income $222 Profit Margin 11% NOPAT $240 Net Operating Profit After Tax = Operating Income * (1-Tax Rate)
    70. 70. 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 0 1 2 3 4 5 Marginal Savings $ - $ 2,000 $ 2,000 $ 2,000 $ 2,000 $ 2,000 Marginal Costs & Project Expenses $ - $ (1,000) $ (1,000) $ (1,000) $ (1,000) $ (1,000) Net Savings (pre Depr. & Taxes) $ - $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 Depreciation Expenses (non Cash) $ - $ (2,286) $ (3,804) $ (2,534) $ (1,700) $ (1,380) Net Operating Profit (pre-Taxes) $ - $ (1,286) $ (2,804) $ (1,534) $ (700) $ (380) Income Taxes $ - $ 514 $ 1,122 $ 614 $ 280 $ 152 Project Net Operating Profit After Taxes $ - $ (772) $ (1,682) $ (920) $ (420) $ (228) Cash Flow from Operations $ - $ 1,514 $ 2,122 $ 1,614 $ 1,280 $ 1,152
    71. 71. EVA – Weighted Average Cost of Capital <ul><li>WACC is calculated as the proportional cost of debt vs. equity. </li></ul><ul><li>WACC = w d *(1-T)* r d + w e *r e </li></ul><ul><ul><li>w d = debt portion of value of corporation </li></ul></ul><ul><ul><li>T = tax rate </li></ul></ul><ul><ul><li>r d = cost of debt (rate) </li></ul></ul><ul><ul><li>w e = equity portion of value of corporation </li></ul></ul><ul><ul><li>r e = cost of internal equity (rate) </li></ul></ul><ul><li>Example: </li></ul><ul><ul><li>The company has 40% debt and 60% equity </li></ul></ul><ul><ul><li>Shareholders expect a 8% return for their investment in company shares </li></ul></ul><ul><ul><li>The company pays pay 5% interest for debt. </li></ul></ul><ul><ul><li>Tax rate is 40% </li></ul></ul><ul><ul><li>WACC = 40%*(1-40%)*5% + 60%*8% = 6% </li></ul></ul><ul><li>For simplicity, the discount rate may be used when calculating the EVA on a project investment </li></ul>The weighted average cost of capital (WACC) is the minimum return that a company must earn.
    72. 72. EVA – Invested Capital on Balance Sheet <ul><li>Invested capital is the total cash based investment </li></ul><ul><li>NIBCL is “free money” debt, representing money that the company owes and must pay within one year and does not require interest payments </li></ul><ul><li>Examples of NIBCL: </li></ul><ul><ul><li>Accounts payable </li></ul></ul><ul><ul><li>Unpaid taxes due by the end of the year </li></ul></ul><ul><li>In the example, Invested Capital: </li></ul><ul><li>$172,200 - $27,100 = $145,100 </li></ul>Invested capital is equivalent to total assets (or total liability and equity) less non-interest bearing current liabilities (NIBCL). NIBCL Example Assets Cash $ 4,200 Securities $ 2,800 Accounts Receivable $ 16,600 Inventory $ 49,000 Prepaid Expenses $ 1,600 Other Current Assets $ 3,300 Total Current Assets $ 77,500 Long Term Investments $ 8,700 Property, Plant & Equipment $ 76,000 Intangible Assets $ 10,000 Total Assets $ 172,200 Liabilities $ - Short Term Debt $ 5,000 Accounts Payable $ 19,800 Taxes Payable $ 1,000 Other Payables $ 6,300 Total Current Liabilities $ 32,100 Long Term Debt $ 50,000 Total Liabilities $ 82,100 Equity Capital Stock $ 70,000 Additional Paid in Capital $ 3,700 Retained Earnings $ 16,400 Total Equity $ 90,100 Total Debt & Equity $ 172,200
    73. 73. EVA – Invested Capital for a Project <ul><li>EVA determines whether the net profit of an investment exceeds the opportunity cost of the capital for that investment </li></ul><ul><li>Invested capital for a project can be considered as the CAPEX plus the sustainable, net change in working capital (inventory, A/P, A/R). </li></ul><ul><li>The assumption is that there is an opportunity cost interest charge (i.e. discount rate or WACC) associated with any net change in capital. </li></ul>Invested capital for a project can be defined as the annual book value of all assets impacted by the project. Example Capital Expenditures (Depreciable) Initial Investment Equipment $ 9,000 Systems $ 5,000 Total Capital Investment $ 14,000 Annual Depreciation 0 1 2 Equipment $ - $ 1,286 $ 2,204 Systems $ - $ 1,000 $ 1,600 Total Depreciation $ - $ 2,286 $ 3,804 Asset Book Value 0 1 2 Equipment $ 9,000 $ 7,714 $ 5,510 Systems $ 5,000 $ 4,000 $ 2,400 Ending Book Value $ 14,000 $ 11,714 $ 7,910 Working Capital 0 1 2 Change in Working Capital $ - $ (10,000) $ (10,000) Project Invested Capital 0 1 2 Long Term Assets $ 14,000 $ 11,714 $ 7,910 Working Capital $ - $ (10,000) $ (10,000) Net Invested Capital 14,000 1,714 (2,090)
    74. 74. EVA – Project Example The example below illustrates the EVA calculation for project investment.
    75. 75. 9. Conduct Qualitative Analysis <ul><li>Decision making requires a connection between the left brain (logical side) and the right brain (intuitive, creative, and holistic side) </li></ul><ul><li>We cannot expect executives to make a decision if we only address one half of their decision making requirements </li></ul><ul><li>Therefore, we must also address the qualitative aspect of the business case. Example considerations: </li></ul><ul><ul><li>Priority of Investment </li></ul></ul><ul><ul><li>Business Climate </li></ul></ul><ul><ul><li>Critical Success Factors </li></ul></ul><ul><ul><li>Feasibility of Assumptions </li></ul></ul><ul><ul><li>Risks </li></ul></ul><ul><ul><li>Resource Availability </li></ul></ul><ul><ul><li>Executive Preferences </li></ul></ul><ul><ul><li>Intangible Benefits </li></ul></ul><ul><li>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. </li></ul>A business case is more than the numbers; it must address other factors that weigh in the final decision.
    76. 76. 10. Package the Business Case <ul><li>Statement defining purpose of meeting…make sure they understand what you expect of them </li></ul><ul><li>Overview of project scope and objectives…put the discussion in context </li></ul><ul><li>Overview of project analysis & results…briefly describe how you got to this point </li></ul><ul><li>Key business assumptions…summarize major assumptions that lead to your recommendation </li></ul><ul><li>Recommendation…clearly state what you recommend and why </li></ul><ul><li>Anticipated Benefits…put in terms important to the audience </li></ul><ul><ul><li>Financial </li></ul></ul><ul><ul><li>Key Metrics </li></ul></ul><ul><ul><li>Qualitative </li></ul></ul><ul><li>Required Investment…define how much, when, and who </li></ul><ul><ul><li>Financial </li></ul></ul><ul><ul><li>Organizational </li></ul></ul><ul><li>Financial analysis…summarize the results of the discounted flow assessment </li></ul><ul><li>Critical success factors…address risks and mitigating actions leadership should take </li></ul><ul><li>Project roadmap…create a summary gantt chart of major work streams </li></ul><ul><li>Supporting analysis and assumptions (appendices)…organize in a separate file or document for easy access </li></ul>Example components of a board level business case:
    77. 77. Ten Checklist Questions <ul><li>Does the business case address a key business priority? </li></ul><ul><li>Are the scope and objectives of the business class clear? </li></ul><ul><li>Are the cash flow projections and financial analysis clearly defined? </li></ul><ul><li>Is the supporting analysis easy to follow? </li></ul><ul><li>Are the assumptions credible? </li></ul><ul><li>What other alternatives were considered? </li></ul><ul><li>What are the critical success factors? </li></ul><ul><li>How will it be implemented? </li></ul><ul><li>What are the risks? </li></ul><ul><li>What actions are expected of the decision maker? </li></ul>These ten questions make a good checklist when reviewing a business case.
    78. 78. Questions? Questions The Answer To A Good Question Can Illuminate A Room Full Of Dim Bulbs

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