2. The Decision-Making Model.
PROBLEM STATEMENT
PROBLEM STATEMENT
CRITERIA
CRITERIA
ALTERNATIVES
ALTERNATIVES
NON-FINANCIAL ANALYSIS
NON-FINANCIAL ANALYSIS FINANCIAL ANALYSIS
FINANCIAL ANALYSIS
MAKE A CHOICE
MAKE A CHOICE
IMPLEMENTATION PLAN &
IMPLEMENTATION PLAN &
FOLLOW UP
FOLLOW UP
2
3. Financial analysis is
complex
• Financial analysis deserves special
consideration for two reasons.
– Firstly, it is often regarded as the most
complex part of the evaluation process and
– secondly, financial efficiency and
effectiveness are very powerful strategic goals
3
4. REASONS FOR FINANCIAL
EVALUATION
– The purpose of this chapter is to enhance
your understanding of financial evaluation so
that you can:
• initiate and perform financial evaluations in support
of the analysis of decision alternatives,
• understand the implications on the business
decision of cash flow estimates into the future,
• develop a sufficient understanding of financial
analysis to be able to incorporate financial
considerations in the business case.
4
5. REASONS FOR FINANCIAL
EVALUATION
• There are two objectives of financial
evaluation:
• To array
• To quantify the expected results
– Financial evaluation is the comparison of
investment costs to financial benefits
received.
5
6. INVESTMENT COSTS
DEFINED
• A cost is defined as a resource used to
achieve an objective.
• In general terms, any cost could
represent:
• an increase or potential increase in capacity
• a decrease or potential decrease in operating
costs
• a change in processes or procedures for technical
improvement alone
• a change in processes or procedures to satisfy
non-quantitative factors. 6
7. INVESTMENT COSTS
DEFINED
• There are five key points associated with
this definition of investment costs.
1. Investment costs are not just capital.
2. Investments represent a change in future
conditions.
3. Investments relate to corporate objectives
and business unit strategies.
4. Investments deal in a world of uncertainty.
5. Investment benefits and costs are assumed
to be quantifiable.
7
8. COST OF CAPITAL DEFINED
• "Cost Of Capital" (also called "hurdle
rate") is more appropriately thought of as
an opportunity cost of capital.
8
9. COST OF CAPITAL DEFINED
• The investment hurdle rate calculation
used by industry is:
The prime lending rate (the rate for rented money)
plus a premium for general economic risk (inflation)
plus a premium for economic risk faced in this
industry
plus a premium for risk faced in dealing with assets
of this type,
9
10. CASH FLOW ANALYSES
• Time Value of Money
• It is necessary to modify the streams of
benefits and costs so that they can be
compared at a single point in time. The
comparison is termed "Discounted Cash
Flow".
10
11. DISCOUNTED CASH FLOW
• The objective is to compare cash streams
at a single point in time with reference to
the established hurdle rate.
11
12. Simple Interest Example
• An investment is made and the proceeds from
interest are withdrawn at the end of each year.
• When considering an investment of $1,000
made at an interest rate of 12% for 5 years, the
simple interest return on the investment is:
Simple Interest = P x i x n
Simple Interest = l000 x .12 x 5
Simple Interest = $600
(The simple interest formula assumes that the interest return
on the $1,000 is not reinvested.)
12
13. DISCOUNTED CASH FLOW
• Compound Interest Example
• Consider this time that the annual return
on our $1000 investment is reinvested.
The value at the end of 5 years, where "S"
is the compound sum is calculated as
follows.
S = P x (l+i)n
S = l000(l+.12)5
S = 1000 x l.76234
S = $1762.34
13
14. DISCOUNTED CASH FLOW
• Present Value Example
• In order to conduct an analysis of cash flow into
the future, we need to take a mirror image of
“compounding” so that we can see how much
value there is today in the prospect of receiving
cash some time in the future.
• A series of tables are presented in the
following figures for discussion.
14
15. DISCOUNTED CASH FLOW
– Figures 8.2 and 8.3 show the present value of
dollars to be received in the future.
– $1.00 to be received in 20 years in a 10%
world is the same as $.149 to be received
today. $1.00 to be received in 20 years in the
30% world is the same as $.005 today.
15
16. DISCOUNTED CASH FLOW
• Figures 8.4 & 8.5, “Compound Amounts”
shows how money accumulates over time
using the cost of capital as the investment
rate.
• In a 10% world, one dollar will accumulate
to $6.727 in 20 years, and in a 30% world
one dollar will accumulate to $190.05 in 20
years.
16
17. DISCOUNTED CASH FLOW
• The discount rate or “Opportunity Cost of
Capital” incorporates the financial risks of
a project in three ways:
• The streams of benefits in the form of either
savings or revenues are not entirely predictable.
• The value of money changes in terms of
inflationary purchasing power.
• There is some uncertainty about the changing
"rental rate" for funds.
17
18. CASH FLOW ESTIMATES
• Keep in mind that "sunk costs" (those
relating to an investment that have already
been made), are not relevant to the
decision at hand.
18
19. Types of Cash Flows
• Cash outflows: (expenditures made to
start the project and keep it going for its
whole life)
– Initial investment
– Recurring maintenance costs
– Recurring operating costs and negative
benefits
– Periodic improvement costs
19
20. Types of Cash Flows
• Cash inflows: (financial benefits received
from the project for its whole life)
– Incremental Revenues
– Incremental Savings
– Proceeds on Disposal
• We deal only with cash inflows and
outflows that are directly attributable to the
decision at hand.
20
21. ANNUAL CASH INFLOWS
PRESENT
VALUE FACTOR
dollars 0 1 2 3 4 5
INITIAL 400,000 1.000 (400,000)
INVESTMENT
136,350 .909 150,000
123,900 .826 150,000
Present value of 112,650 .751 150,000
annual cash
flows
102,450 .683 150,000
93,150 .621 150,000
TOTAL 568,500
BENEFITS (sum of the present values of cash inflows)
NET PRESENT $168,500
VALUE (difference between the present value of inflows and the initial investment)
BENEFIT COST RATIO = $568,500/$400,000 = 1.42
PAYBACK PERIOD IS $400,000/$150,000 = 2.67 YEARS
INTERNAL RATE OF RETURN IS 25.41%
21
22. Net Present Value (NPV)
• The Net Present Value of an expenditure
is determined by subtracting the sum of
the discounted costs from the discounted
benefits. In formula terms:
• Net Present Value = Sum of Discounted
Benefits ‑ Sum of Discounted Costs
22
23. Benefit/Cost Ratio
• The ratio between the sum of the discounted
benefits and the sum of the discounted costs. If
the Benefit/Cost ratio is greater than 1, then the
project is viable from the financial point of view.
• This simple variation of Net Present Value
assists in ranking a series of investment projects
that are being reviewed.
23
24. Payback or Payout
• The concept of payback or payout does not
require using discounted cash flow information.
• We are less certain of predictions as they are
made farther into the future. Therefore, an
investment that generates sufficient cash
benefits to pay for itself early in its life is less
risky than one that takes longer to pay for itself.
24
25. Internal Rate of Return
• The internal rate of return is the true rate
of interest earned by the investment.
• A $400,000 investment that earns
$150,000 per year for 5 years is yielding a
25.41% rate of return. When we compare
this to the hurdle rate of 10% we are
performing well.
25
26. Comparing Alternatives
• All three of the discounted cash flow
methods may be used to rank alternatives.
However, the user of a financial evaluation
must be aware of what the methods
indicate.
26
27. Comparing Alternatives
– Net present value is the conceptually superior
method.
– The benefit cost ratio has the advantage of
enabling comparison of projects of different
sizes
– cash payback illustrates the amount of time
that you are at risk.
– The internal rate of return lets you test the
integrity of the discount rate.
27
28. Critical value analysis
• Critical value analysis is a method of
evaluation that is useful when the benefits
or costs of a project are non-financial in
nature
28
29. Marginal value analysis
• As a final measure of the quality of
benefits we should attempt to identify the
marginal benefits that flow from marginal
dollars. We might be able to attract 90% of
the benefits by spending 50% of the
dollars.
29
30. Chapter Summary
• There are a wide variety of methods for
evaluating expenditure alternatives. Some
rely on monetary values and financial
evaluation; some rely on qualitative
analysis and intrinsic evaluation.
30
31. Chapter Summary
• The analysis and evaluation of alternatives to an
expenditure initiative must be:
• balanced/objective
• realistic/attainable
• easily understood
• appropriate for the situation.
• We also discovered that financial evaluation can be fairly
complicated. It is hoped that the spreadsheet provided
as a supplement to this chapter, will make financial
valuation much easier. (see appendix to chapter 8).
31
32. Closing Remarks
• The next step is to make a choice. If our non-
financial and financial evaluation has been
accurate and relevant, making a choice will be
easy. If our evaluation systems are flawed,
making a choice may be impossible.
• Chapter 9 will deal with making choices and
developing action plans so that choices are
followed through.
32
