Académique Documents
Professionnel Documents
Culture Documents
A Project Financial Evaluation is an in-depth investigation of cash flow and risk with the object of determining a project's eventual return on investment.
Significance
The PFE is meant to look at all the fiscal factors involved in undertaking the project; without it, a business entity does not have the information it needs to make an informed decision about a given project's scope and risks.
Features
Each PFE is different, but each involves the careful definition of each factor that a project represents -- its cash flow, insurances, capital outlay and the time line over which the costs will be recouped and the profits realized.
Considerations
In a small-business situation, it's ideal that a consultant be brought in to administer a PFE in order for the work to be truly subjective; if that is not possible, there is a range of software on the market that can help.
Misconceptions
There are many modalities and definitions, but there are not any set-in-stone rules regarding the content or administration of a PFE. The only imperative is thoroughness.
Project managers perform a cost benefit analysis when they need to make a project decision. Typically using a spreadsheet tool such as Microsoft Excel, Google Spreadsheets or Quickbooks, they analyze the costs associated with a given investment calculated over a three-year period to generate a net present value, payback and other metrics needed to make a good financial decision. For example, a cost benefit analysis for a training development project usually involves measuring the cost of creating the training materials and subtracting savings generated by personnel operating more efficiently. More complex cost benefit analyses involve multiple costs and numerous benefits.
Forecasting
Cash flow forecasts help project managers predict whether income will cover the cost of operations. Project managers can download a template from a website, such as the Microsoft Office Templates website, or develop their own format. Then by entering income expected and expenses for each month and comparing the values using formulas, the project manager can prepare a statement to show optimistic or pessimistic cash flow outlook scenarios. Typically a forecast covers one to two years. Cash flow forecasts provide a way for project managers to determine if an activity is a viable option.
Break-even Analysis
Project managers complete a break-even analysis to determine the level of output at which the money generated by the product or service produced by the project equals the cost of developing it. For example, project managers use free online tools, such as the Project.net software, to maintain a project dashboard and ensure that projects tasks produce output that helps manage projects.
Budget Tracking
Project managers use budget tracking software, such as Clarizen software, to determine if project investments make sense over time, after comparing the monetary value both today and in the future. Software tools allow project managers to define hourly rates for resources, customize billing rates and analyze resource usage. These tools and techniques help keep the project on track by ensuring expenditures, such as specialized consulting, software licenses and hardware costs, are allowed within the allotted funding.
At the simplest level of analysis, you'll want to make sure that the total costs of any major project you undertake are less than the total benefits resulting from the project. You could simply add up the costs, and then add up your expected revenue increases and cost savings over the next few years, and compare the two. However, if you did that, you'd be ignoring the fact that many of the costs will be incurred at the beginning of the project, while many of the revenues or cost savings will occur later, over a period of months or, more likely, years. We've reviewed a number of more formal ways to evaluate the costs or benefits that a major purchase or project will bring to your company. The most commonly used include:
payback period analysis accounting rate of return net present value internal rate of return
Each of these methods has its advantages and drawbacks, so generally more than one is used for any given project. And no financial formula, or combination of formulas, should be used to the exclusion of common sense. A project may "fail" your tests under some or all of these methods, but you might decide to go forward with it anyway because of its value as part of your long-range business plan.
Thus, if a project cost $50,000 and was expected to return $12,000 annually, the payback period would be $50,000 $12,000, or 4.16 years. If the return from the project is expected to vary from year to year, you can simply add up the expected returns for each succeeding year, until you arrive at the total cost of the project. For example, in our previous cash flow example, the project costs $100,000 and the expected returns were as follows:
The project would be completely paid for about 10 1/2 months into the fourth year, because $100,000 (cost of project) is equal to all of the first three years' revenues, plus $28,477. $28,477 is equal to about 10.7/12 of the fourth year's revenues.
For purposes of this formula, depreciation is calculated very simply, using the straight-line method: Depreciation = Cost - Salvage Value Useful Life
As an example of how ARR works, let's say you're looking at equipment costing $7,500 that is expected to return roughly $2,000 per year for five years. After five years you'll sell the equipment for $500. The depreciation would be ($7,500 - $500) 5, or $1,400. ARR = $2,000 - $1,400 = 8% $7,500
Using ARR can give you a quick estimate of the project's net profits, and can provide a basis for comparing several different projects. Under this method of analysis, returns for the project's entire useful life are considered (unlike the payback period method, which considers only the period it takes to recoup the original investment). However, the ARR method uses income data rather than cash flow and it completely ignores the time value of money. To get around this problem, you should also consider the net present value of the project, as well as its internal rate of return.
Bear in mind, though, that NPV analysis is generally used to evaluate the project's cash flows, rather than the income from the project that would be shown on an income statement. Why? Because the income statement factors in depreciation, but depreciation is not an out-of-pocket expense. For instance, if revenue of $10,000 is reduced to $7,000 of income because of a $3,000 depreciation deduction, you still have the use of the full $10,000. So, the cash flow figure of $10,000 is the more instructive one to look at. However, if you are very concerned about the appearance of your income statement (for example, if you anticipate putting the business up for sale or seeking major financing in the future, or if you're under stockholder pressure to show more income) you may decide that the income figure is more appropriate to use. How do you compute NPV? The easiest way is to use a good financial calculator. If you don't have one, or don't want to take the time to learn how to use one, you can use the present value table contained among the Business Tools. If you are mathematically inclined and have a calculator with exponential functions, you can also use the following formula:
(When using this formula, CFx = cash flow in period x, n = the number of periods, and r = the discount rate.)
Whenever you do time value of money calculations to find a present or future value (such as NPV), you'll need to specify an interest rate, known as the discount rate. Choosing the appropriate discount rate is a very important part of the process.
Discount Rate
How can you quickly estimate your cost of borrowing, which is used as the "discount rate," for purposes of analyzing a major purchase decision? If you are planning to finance the purchase and you know what the interest rate on the loan would be, you can use the rate charged on the loan as the cost of borrowing for the project. Therefore, you would use the loan's rate as the "discount rate" in computing the net present value for the project. (If the rate is variable, you may have to take a guess as to the average rate over the loan period, or do the computation under worst-case and best-case scenarios.) To fine-tune your calculations, you'll want to account for the fact that interest on business loans is tax-deductible. So, you can multiply the nominal interest rate on the loan by one minus the marginal tax rate for the business, to arrive at the tax-adjusted interest rate. Example If the rate on your loan was 8.5 percent and your marginal combined federal and state income tax rate was 40 percent, your tax-adjusted interest rate on the loan would be 5.1 percent (1- 0.40 = 0.60; 0.085 x 0.60 = 0.051).
If you are not financing your purchase, theoretically, you should attempt to compute an average cost of capital for your business that reflects all your current funding sources, including debt and owner's equity. Computing your true cost of capital can be rather timeconsuming and complicated, and you'll probably need your accountant's assistance to do it accurately. The calculation depends on a number of economic conditions, opportunity costs, and business risks faced by the company. What's more, using this figure assumes that additional capital can be obtained from similar sources in the same proportion, and at the same rates. For many small businesses, this may not be a realistic assumption. Instead, you can use your average cost of borrowing as the discount rate. Example The following figures reflect the cost to Clear Corporation of borrowing from each external source that it is currently using. We'll assume that Clear's common stock is currently not paying any dividends.
Funding Source Preferred Stock Bonds Loans-Community Devel. Revolving Loan Term Loan Total
% of Total Interest Rates Rate Factor 26% 26% 10% 7% 31% 100% 8.00% 8.50% 5.50% 11.00% 9.75% = 2.08% = 2.08% = .55% = .77% = 3.02% 8.5%
In this example, the company's average cost of borrowing would be 8.5 percent. Note that interest rates on all loans must first be adjusted to account for tax benefits, as described above.
If you are very concerned about the appearance of your income statement (for example, if you anticipate putting the business up for sale or seeking major financing in the future, or if you're under stockholder pressure for increased income) you may decide that the income figure is more appropriate to use. How do you compute the IRR? The easiest way is to use a good financial calculator. If you don't have one, or don't want to take the time to learn to use one, you can also use the present value tables located in Business Tools. Tools to Use Among the Business Tools is a simple "present value of a series of $1 payments" table that you can use to figure the IRR of your project.
Using the Present Value Tables If you want to use the present value tables to calculate the IRR of your project, you must first compute the number to look up in the tables. Do that by dividing your expected net cash outflow for the project by your expected average annual net cash inflow. For example, in our example above, the cost of the project (net cash outflow) was $7,500, and the average annual net cash inflow was $2,000. $7,500 $2,000 = 3.8 Then, look at the row corresponding to the number of years the project or equipment will be in use (in this case, five). Look across the rows until you find the number that is closest to the result you found (3.8). Then look at the top of the column in which the closest number was found, to see the interest rate that is your IRR (in this case, 10 percent). One problem with the IRR is that if the expected cash inflows vary greatly from year to year, it's very difficult and time-consuming to calculate the interest rate, though it can be done by using the following math formula. Using a Math Formula For those who are mathematically inclined, you can use the following formula (which is very similar to the formula used to find the net present value. The main difference is that in the IRR formula, you must solve for the interest rate, r.
(When using this formula, CFx = cash flow in period x, and n = the number of periods.)