1. Financial Analysis
You need to know how to calculate costs and benefits when you conduct preliminary investigations, evaluate projects, and make recommendations to management

2. Objectives of the sessions
Understand the steps in conducting a Financial Analysis
Identify the costs
Identify the benefits
Assess the financial indicators to determine if the project is financially favourable.
Notes: 2

3. Defining Costs There are different ways of defining costs: By type:
By function:
By time:
Recurring costs
Non-recurring costs
Capital costs
Operating costs
Development costs
Operational costs
Maintenance costs
By behaviour:
Variable costs change in proportion to the amount of output produced.
Fixed costs remain the same, no matter how much the business produces.
Direct costs are costs which can be identified directly with the production of a good or service; e.g. raw materials.
Indirect costs are costs which cannot be matched against each product because they need to be paid whether or not the production of good or services takes place; e.g. rent on the premises
Notes:

4. Capital Costs
Capital costs are the expenses incurred in purchase of items that are recorded as assets; their value is depreciated over time and they are recorded in the Balance Sheet.
Are you able to identify the capital costs for your organisation for the following items:
Equipment
Non-consumable materials*
Infrastructure
*Non-consumable materials are capital costs because these are materials that persist (eg. furniture, bricks)

5. Revenue or Operating Costs
Operating costs are expenses incurred in the execution of the project or in the operation of the business (after the project) They are not depreciated over time and are recorded in the profit and loss statement.
Identify the operating costs for your organisation:
Training
System administration
Equipment hire
Consumable materials*
Travel
Accommodation
Internal business resources
Internal IT resources
External resources
Office accommodation
Licenses
Support
*Consumable materials are operating expenses because they are materials that are used up by the project (eg. stationery, batteries)

6. Cost allocation
The process of identifying, aggregating, and assigning costs to cost objects.
A cost object is any activity or item for which you want to separately measure costs. Examples of a cost object are a product, a research project, and a department.
Cost allocation is used for financial reporting purposes, to spread costs among departments or inventory.
Allocating variable costs: straightforward. - based on volumetric measures. (w.r.t. output)
Allocating fixed costs: more difficult. --many joint or common costs, no unique method. Costs should be allocated to those who cause them.
Direct costs can be physically traced to each department
Indirect costs must be allocated

7. Identifying the benefits
Identify the benefits that the project will provide, and the value that can be assigned to each benefit.
There are two types of benefits:
Tangible benefits: where the £ value of the benefit can be easily assigned because values are readily measurable.
Intangible benefits: where the £ value of the benefit is not able to be assigned.
Notes:

8. Examples of tangible benefits
Reduce labour costs
Reduce equipment expense
Reduce space & overhead costs
Reduce inventory carrying expense
Reduce accounts receivable & bad debts
Increase sales by 10%
Notes:

9. Examples of intangible benefits
Improve customer service
Make better business decisions
Increase market share
Better managed resources
Improve company image
Notes:

10. How are benefits identified…
The sponsor of the project is the best person to identify the benefits. The sponsor owns the benefits.
Consult with a number of different areas that are going to be impacted by the solution to identify additional benefits
Brainstorming is a useful technique for identifying possible benefits.
Notes:

11. Capital budget decision making

12. Investment appraisal methods:
An important step in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments.
Two methods: -
Traditional methods; include the Average Rate of Return (ARR) and the Payback method
Discounted cash flow (DCF) methods use Net Present Value (NPV) and Internal Rate of Return (IRR) techniques

13. Traditional Methods Payback:
This is literally the amount of time required for the cash inflows from a capital investment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period. Payback is often used as an initial screening method.
Payback period = Initial payment / Annual cash inflow
The shorter the payback period, the better the investment
Payback summary
It is probably best to regard payback as one of the first methods you use to assess competing projects.
It could be used as an initial screening tool, but it is inappropriate as a basis for sophisticated investment decisions. 2

14. Payback Method
Assume that an organisation is considering buying some equipment (Machine 1) for £210,000, with an estimated useful life of 11 years, and zero predicted residual value.
Managers expect use of the equipment to generate £35,000 of net cash inflows from operations per year.
How long would it take to recover the investment?

15. Payback Method How long would it take to recover the investment?
£210,000 ÷ £35,000 = 6 years
6 years is the payback period.

16. Payback Method
Suppose that an alternative to the £210,000 piece of equipment, there is another one (Machine 2) that also costs £210,000 but will save £42,000 per year during its five-year life.
What is the payback period?
£210,000 ÷ £42,000 = 5 years
Which piece of equipment is preferable?

17. Payback Method
Machine 1 is preferable because it will continue to generate net cash inflows for four years after its payback period.
This will give the company an additional net cash inflow of £140,000.

18. Payback Method
When cash flows are uneven, calculations must take a cumulative form.
Assume that an organisation’s investment is going to yield net cash savings of £160,000, £180,000, and £110,000 over its life.
The initial investment is £250,000.
What is the payback period?

19. Payback Method Year 1 brings in £160,000.
Recovery of the amount invested occurs in Year 2.

20. Payback Method Payback 1 year
£90,000 needed to complete recovery £180,000 net cash inflow in Year 2
1 year year = 1.5 years or,
1 year and 6 months

21. Average Rate of Return:
Average rate of return expresses the profits arising from a project as a percentage of the initial capital cost.
The definition of profits and capital cost are different depending on which textbook you use e.g. the profits may be taken to include depreciation, or they may not.
One of the most common approaches is as follows:
ARR = (Average annual revenue / Initial capital costs) * 100
A simple example to illustrate the ARR:
A project to replace an item of machinery is being appraised. The machine will cost £ and is expected to generate total revenues of £ over the project's five year life. What is the ARR for this project?
ARR = ((£ / 5) / ) * 100 = (£9 000/ ) * 100 = 3.75%

22. Advantages of ARR
As with the Payback method, the chief advantage with ARR is its simplicity.
There is also a link with some accounting measures that are commonly used. The Average Rate of Return is similar to the Return on Capital Employed in its construction; this may make the ARR easier for business planners to understand.
The ARR is expressed in percentage terms and this, again, may make it easier for managers to use.
Arguments against ARR
Firstly, the ARR doesn't take account of the project duration or the timing of cash flows over the course of the project.
Secondly, the concept of profit can be very subjective, varying with specific accounting practice and the capitalisation of project costs. As a result, the ARR calculation for identical projects would be likely to result in different outcomes from business to business.
Thirdly, there is no definitive signal given by the ARR to help managers decide whether or not to invest. This lack of a guide for decision making means that investment decisions remain subjective

23. Try these questions
A project requires a capital outlay of £ and earns the following cash inflows over the following seven years (all £k):
Year 1 2 3 4 5 6 7
Inflows
200
250
300
450
400
150
Calculate the project's payback period.
Calculate the Average Rate of Return for the project.

24. Payback The cumulative cash flows are detailed below:
Year 1 2 3 4 5 6 7
Inflows
(900)
(700)
(450)
(150)
300
700
900
1050
Payback occurs during Year 4. £ revenues are generated in Year 4. Because £ remained to be paid off at the start of Year 4, the payback period is 3 Years + 150/450 = 1/3 rd of a year. Payback = 3 1/3rd years = 3 years and 4 months
Average Rate of Return ARR = (Average annual profits / Initial capital costs) * 100 ARR = (£ / £ ) * 100 = * 100 = 31 %

25. Discounted Cash Flow
Discounted cash-flow (DCF) methods measure all expected future cash inflows and outflows of a project as if they occurred at a single point in time.
The discounted cash-flow methods incorporate the time value of money.
The time value of money means that a pound received today is worth more than a pound received at any future time.
Why? Because it can earn income and become greater in the future.

26. Discounted Cash Flow There are two main DCF methods:
Net present value (NPV) method
Internal rate-of-return (IRR) method

27. The Value of Money The value of money changes over time.
With most projects, the financial benefits are realised at a different time to the costs.
Net present value (NPV) provides a means to compare these by adjusting the value to today’s value.
This is achieved by modifying the future value by a factor that represents the change in value of money from today’s value.
This factor is called the discount factor.
Notes:

28. If you receive cash you are quite likely to save it and put it in the bank.
What a business sacrifices by having to wait for the cash inflows is the interest lost on the sum that would have been saved.
NPV is a technique where cash inflows expected in future years are discounted back to their present value.
This is calculated by using a discount rate equivalent to the interest that would have been received on the sums, had the inflows been saved, or the interest that has to be paid by the firm on funds borrowed.

29. Net Present Value - NPV
Imagine you have £66080 and invest this at 10% rate.
After two years you would receive approx £80000
£60080 and invest this at 10% rate.
After three years you would receive approx £80000
Looking from a different point of view – imagine you received £80k in three years
What is this worth at today’s value
Need to discount this to its present value at the rate we could have expected i.e. 10%

30. Present Value
We will simply use a table to obtain multiplication factor
NPV = Sum of all PV’s less initial investment

31. Net Present Value - NPV £60080 and invest this at 10% rate.
After three years you would receive approx £80000
Looking from a different point of view – imagine you received £80k in three years
What is this worth at today’s value
Need to discount this to their present value at the rate we could have expected i.e. 10%
Multiplication factor from the table: 0.751
Therefore £80k at today’s value = £80k x = £60080

32. Net Present Value Cash Flows 1 2 3 Net initial investment (£250,000)1 2 3
Net initial investment
(£250,000)
Annual cash inflow
£125,000
£130,000
£115,000

33. Net Present Value
Year 10% Inflows Net Cash Inflows
£125,000 £113,625
, ,380
, , Total PV of net cash inflows £307,370 Investment £ 250, Net present value of project £ 57,370
This project is acceptable because its net present value is positive at £57,370.

34. Net Present Value
Assume the organisation is considering another investment that will generate £80,000 per year for three years, and have a residual value of £4,000 at the end of the third year
The cost of this investment is £250,000 including working capital.
The working capital investment of £5,000 is expected to be recovered at the end of year 3.
Our Organisation expects a return of 10%.
Should the investment be made?

35. Net Present Value No, the net present value is negative.
Year % Inflows Net Cash Inflows
£80,000 £72,720
, ,080
, ,080
( ) 9, ,759
Total PV of net cash inflows £ 205,639 Investment £ 250, Net present value of project (£ 44,361)
No, the net present value is negative.

36. NPV Exercise Calculate NPV Why is NPV Important?

37. Internal Rate of Return
Is defined as the discount rate at which an investment has a zero net present value.
The internal rate of return equates to the interest rate, expressed as a percentage, that would yield the same return if the funds had been invested over the same period of time.
Therefore, if the internal rate of return for the project is less than the current bank interest rate it would be more profitable to put the money in the bank than execute the project

38. The Internal Rate of Return (IRR)
A positive NPV is produced by our DCF calculations, a project is worthwhile.
When there are competing projects, we should select the one that produces the highest NPV.
But sometimes a firm will want to know how well a project will perform under a range of interest rate scenarios.
The aim with IRR is to answer the question: 'What level of interest will this project be able to withstand?' Once we know this, the risk of changing interest rate conditions can effectively be minimised.
The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested.
Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero.

39. Making the investment decision
Let's set out the criteria for accepting or rejecting investment opportunities, using the NPV and IRR.
Imagine a scenario where the managers of a firm are considering whether to accept or reject an investment project, on the basis of their acquiring the funds necessary at a known rate of interest.
The NPV approach asks if the present value of cash inflows less the initial investment is positive, at the current borrowing rate.
The IRR approach asks if the IRR on the project is greater than the borrowing rate
Illustration of NPV & IRR
An initial investment of £ in a project produces cash inflows of £ 750, £ 750, £ 900, £ 900 and £ 595 at 12 month intervals. The cost of capital to finance the project is 12 %.
You are required to decide whether the project is worthwhile using:
The Net Present Value
The Internal Rate of Return
Year 1 2 3 4 5
Cash flow
(2500)
750
900
595

40. The cost of capital to finance the project is 12 %.
NPV
The cost of capital to finance the project is 12 %.
Year
Cash flow
Discount 12%
Present value
(2500)
1.000 1
750 2 3
900 4 5
595
Net present value

41. NPV
A positive NPV makes the project worthwhile because the cost of tying up the firm's capital is compensated for by the cash inflows that result.
Year
Cash flow
Discount 12%
Present value
(2500)
1.000 1
750
0.893
669.75 2
0.797
597.75 3
900
0.712
640.80 4
0.636
572.40 5
595
0.567
337.37
Net present value
£318.07

42. IRR
The calculation for NPV used a 12 % discount rate and produced a positive value of £ We need to find a discount rate that produces a negative NPV. Let's try 20 %.
Year
Cash flow
Discount 20%
Present value
(2500)
1.000 1
750 2 3
900 4 5
595
Net present value

43. IRR
The calculation for NPV used a 12 % discount rate and produced a positive value of £ We need to find a discount rate that produces a negative NPV. Let's try 20 %.
Year
Cash flow
Discount 20%
Present value
(2500)
1.000 1
750
0.833
624.75 2
0.694
520.50 3
900
0.579
521.10 4
0.482
433.80 5
595
0.402
239.19
Net present value
(£160.66)

44. The IRR lies between 12 % and 20 %
The IRR lies between 12 % and 20 %. But we can get much closer to the precise answer by using arithmetic.
IRR = 12 % + (Difference between the two discount rates )* (Positive NPV / Range of +ve to -ve NPVs)
IRR = 12 % + (8 % * )
IRR = 12 % IRR = %

45. IRR Summary:
The value to a business of calculating the IRR is that its decision-makers are able to see the level of interest that a project can withstand.
In the case where a number of projects are competing for selection, the one that is most resilient can be chosen.

46. Comparison of NPV and IRR
The NPV method has the important advantage that the end result of the computations is expressed in pounds and not in a percentage.
Individual projects can be added to see the effect of accepting a combination of projects.
It can be used in situations where the required rate of return varies over the life of the project.
The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.
Note: Excel has NPV and IRR functions

47. Feasibility analysis Method Benefits Disadvantages Payback
Easy to compute
Easy to understand
Ignores the benefits that occur after the payback period
Ignores the time value of money
Net present value
Accounts for changing value over time, i.e. time value of money
Need to select an appropriate discount rate
Internal Rate of Return
Provides a benchmark for what should and should not be invested in
Need to select an appropriate benchmark IRR
Doesn’t give an indication of the absolute value of a project
Average Rate of Return

48. Summary and Conclusions
A capital budgeting decision involves planning cash flows for a long-term investment
Several methods are used to analyse investment proposals e.g. payback, net present value, internal rate of return
The net present value method, in particular, considers the amount and timing of cash flows
The analysis is based upon estimates of incremental cash flows after tax that will result from the investment

49. Sensitivity Analysis
Projects do not always run to plan. Costs and benefits estimated at an early stage of a project may indicate a profitable project, but this profit could be eroded by an increase in costs or a decrease in the value of the benefits (the revenue).
Sensitivity analysis provides a means of determining the financial impact of this type of fluctuation.
By entering an anticipated percentage increase in costs or decrease in revenue the financial impact on the project can be identified by looking at the change to the NPV or IRR measures.
Notes:

50. 'Return On Investment - ROI' A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.
Return on capital employed
ROCE is sometimes referred to as the "primary ratio”. It tells us what returns (profits) the business has made on the resources available to it
ROCE =
Net Operating Profit
Capital Employed