Académique Documents
Professionnel Documents
Culture Documents
Agenda
Outline of Todays Business Case Training Session:
Introduction to Business Case Development Financial Justification
Terms and Metrics
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
Business = Case
Types of Investment?
An investment can be considered as any type of commitment necessary to create value, most of which can be translated to monetary terms. Example investments:
Capital and Assets
Systems Equipment Building Inventory People Supplies Professional Fees Travel Expenses
Expenses
What is Value?
There are many ways to create value, all of which can be articulated in a business case.
Value =
Revenue Growth Quality Service Flexibility Risks Time Costs Working Capital Taxes
Increase These
Decrease These
7
Financial Justification
Financial Justification
Ideally, financial justification provides the meaningful monetary statistics necessary to drive a decision.
Considerations
What are we comparing against? What is the cost of doing nothing? What financial metrics will be compared (e.g. NPV, IRR, MIRR, EVA, etc.)? What are the positive and negative cash flows for each alternative What is the timing of these cash flows? What is the cash flow horizon? How do we impact the income statement? How do we impact the balance sheet? What will be capitalized vs. expensed? What depreciation method will be used? What is the depreciation time period for each asset? What is the client income tax rate? What rate will be used to determine the NPV of cash flows? How do the numbers stack up and compare? Does the answer change is different assumptions are used? What other factors need to be considered beyond the ROI? What is the level of detail needed to present your recommendation? What questions must be answered to drive a decision? 10
4. Use accounting view of cash flow and ROI (return on investment) 5. Determine depreciation expense
6. Calculate after-tax cash flow 7. Calculate discounted cash flow 8. Assess alternatives based on financial metrics 9. Perform qualitative analysis 10. Package the business case
Comparing the recommended investment with multiple alternatives, including doing nothing, provides a perspective to aid in the decision making process
11
Discount Rate Discounted Payback Discounted Cash Flow (DCF) Net Present Value (NPV) Internal Rate of Return (IRR)
What is the incremental cash flow for each value lever? When will these savings begin? What are the costs associated with the investment
One time Ongoing
Pre-tax cash flow analysis allows for quick and dirty calculations such as Simple ROI and Simple Payback.
14
($200) ($100)
15
($400) ($100)
$250 $1,000
16
($200) ($100)
17
($400) ($100)
$250 $1,000
18
3.0
19
3.0
20
NPV = $141
NPV = $303
21
Payback
NPV
IRR
MIRR
$1.0 M
50%
$0.49 M
23%
18%
6 Year Horizon
$4.0 M
200%
$2.36 M
45%
25%
22
NPV
IRR
MIRR
$1.0 M
$5.0 M initial investment
(Discount Rate = 10%)
20%
2.5
($0.03) M
10%
10%
6 Year Horizon
0
$7.0 M
1 2 3 4 5 6 $5.0 M initial investment
(Discount Rate = 10%)
140%
2.5
$3.71 M
33%
21%
23
OVERAMBITIOUS
Your Ambition Is Noteworthy But Not Very Practical
24
Decrease COGS Reduce Selling Costs Reduce Distribution Costs Reduce Admin. Costs
Reduce Income Taxes Increase Net Operating Profit Before Taxes Increase Net Income
Depreciation Reduce Working Capital Reduce Fixed Assets Reduce Net Capital Reduce % Cost of Capital
25
Gross Margin
Operating Expenses (SG&A)*
EBITDA
*Depreciation Operating Income
Operating Margin
Other Non-Operating Expenses Other Non Operating Revenue
EBIT
Interest Expense Net Profit Before Taxes Taxes Net Income
Profit Margin
$ $ $ $ $ $
$ Total Liabilities $
$ $ $ Total Equity $
27
Financial Ratios
Common financial ratios used in evaluating the financial health of an organization.
2.4 0.9 0.2 $454.0 Liquidity - Ability to meet short term obligations Current Ratio = Current Assets/Current Liabilities Quick (Acid Test) Ratio = (Current Assets - Inventory)/Current Liabilities Cash Ratio = (Cash + Marketable Securities)/Current Liabilities Working Capital = Current Assets Current Liabilities Activity - Ability to effectively utilize assets Days of Cash = Cash/(Sales/365) Average Collection Period (in days) = Accounts Receivable/(Sales/365) Days of Inventory = Inventory/(COGS/365) Receivables Turnover = Sales/Receivables Inventory Turns = COGS/Inventory Asset Turnover = Sales/Total Assets Profitability - Ability to generate profit Net Profit Margin = Net Income/Sales Gross Profit Margin = (Sales - COGS)/Sales Operating Profit Margin = (Sales - COGS - SGA)/Sales Return on Assets = Net Income/Total Assets = Net Profit Margin x Asset Turnover 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 28
Depreciation expense reduces tax liability Generally, it is included as part of operating expenses However, it is a non-cash based expense Therefore, depreciation is added back to net profit after taxes
29
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. Estimated life is the number of years a company expects the asset to last or the amount of measurable production it expects from asset. 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 Several potential depreciation methods may be used (to be further discussed)
30
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 Generally Accepted Accounting Principles (GAAP) is the standard framework of guidelines for financial reporting GAAP Methods for Depreciation
Straight Line Productive Output Declining Balance Sum of the Years Digits
Tax Reporting Methods Modified Accelerated Cost Recovery System (MACRS) is the current method of accelerated asset depreciation required by the United States income tax code. Specific types of assets are assigned to X-year property classes with distinct accelerated depreciation schedules. MACRS is required by the IRS for tax reporting but is not approved by GAAP for external reporting.
33
$120,000 $120,000 $120,000 $120,000 $120,000 $120,000 $ 24,000 $ 24,000 $ 24,000 $ 24,000 $ 24,000 $ 24,000 $ 48,000 $ 72,000 $ 96,000 $120,000
$140,000 $140,000 $116,000 $ 92,000 $ 68,000 $ 44,000 $140,000 $116,000 $ 92,000 $ 68,000 $ 44,000 $ 20,000
35
($24,000) $56,000
($120,000) $140,000
($22,400) ($112,000)
($8,000) $72,000
($120,000) $140,000
($28,800) ($112,000)
36
The MS Excel Function is SYD(cost,salvage,life,per), where Per is the period being depreciated
37
$120,000 $120,000 $120,000 $120,000 $120,000 $120,000 $ 40,000 $ 32,000 $ 40,000 $ 72,000 $ 24,000 $ 16,000 $ 8,000 $ 96,000 $112,000 $120,000 $ 44,000 $ 28,000 $ 20,000
38
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. 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 zerodollar salvage value will be fully depreciated in the first period.
39
Year Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value $ $
1 32% -
2 32%
3 32%
4 32%
5 32%
$140,000 $140,000 $ 94,920 $ 64,356 $ 43,633 $ 29,583 $ 45,080 $ 30,564 $ 20,723 $ 14,050 $ 9,583 $ 45,080 $ 75,644 $ 96,367 $110,417 $120,000
$140,000 $140,000 $ 94,920 $ 64,356 $ 43,633 $ 29,583 $140,000 $ 94,920 $ 64,356 $ 43,633 $ 29,583 $ 20,000
40
41
VDB(cost,salvage,life,start_period,end_period,2,False),
Year 0 1 40% $ $ $ 56,000 $ 56,000 2 40% 3 40% 4 34% $ 30,240 $ 10,240 $ 5 0% $ 20,000 -
Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value
Year Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value $ $
1 30% -
2 30%
3 30%
4 30%
5 41%
$140,000 $140,000 $ 98,000 $ 68,600 $ 48,020 $ 33,614 $ 42,000 $ 29,400 $ 20,580 $ 14,406 $ 13,614 $ 42,000 $ 71,400 $ 91,980 $106,386 $120,000
$140,000 $140,000 $ 98,000 $ 68,600 $ 48,020 $ 33,614 $140,000 $ 98,000 $ 68,600 $ 48,020 $ 33,614 $ 20,000
44
$120,000 $120,000 $120,000 $120,000 $120,000 $120,000 $ 18,000 $ 30,000 $ 30,000 $ 24,000 $ 18,000 $ 18,000 $ 48,000 $ 78,000 $102,000 $120,000
$140,000 $140,000 $122,000 $ 92,000 $ 62,000 $ 38,000 $140,000 $122,000 $ 92,000 $ 62,000 $ 38,000 $ 20,000
46
Illustration
Depreciation Expense Comparison
$60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $1 2 3 Years
47
Straight Line Sum of the Years Digits Fixed Declining Balance 150% Declining Balance Double Declining Balance Productive Output
Depreciation - MACRS
Modified Accelerated Cost Recovery System (MACRS) is the current method of accelerated asset depreciation required by the United States income tax code.
Assets are grouped into property classes The depreciation is predetermined by the MACRS table for each property class The two most common asset classes besides real estate are the five-year and the sevenyear asset class.
The five-year asset class includes information systems, computers, and vehicles The seven-year class includes most machinery and equipment
Residual value is ignored All fixed assets are assumed to be put in and taken out of service in the middle of the year. Therefore:
For the five-year class assets, depreciation is spread over six years. For seven-year class assets, depreciation is spread over eight years. The useful life is 39 years for nonresidential real property. Depreciation is straight line using the midmonth convention.
It is arguable as to whether a company may use the MACRS method for both financial statement and tax purposes 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.
48
A half-year depreciation is allowed in the first and last recovery years. Depreciation rates:
The 3, 5, 7, and 10-year classes begin with double declining balance depreciation 15- and 20-year classes begin with 150% declining balance depreciation. All classes convert to straight-line depreciation in the year highlighted
*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).
Recovery Year 3 5 7 10 15 1 33.33% 20.00% 14.29% 10.00% 5.00% 2 44.45% 32.00% 24.49% 18.00% 9.50% 3 14.81% 19.20% 17.49% 14.40% 8.55% 4 7.41% 11.52% 12.49% 11.52% 7.70% 5 11.52% 8.93% 9.22% 6.93% 6 5.76% 8.92% 7.37% 6.23% 7 8.93% 6.55% 5.90% 8 4.46% 6.55% 5.90% 9 6.56% 5.91% 10 6.55% 5.90% 11 3.28% 5.91% 12 5.90% 13 5.91% 14 5.90% 15 5.91% 16 2.95% 17 18 19 20 21
20 3.75% 7.22% 6.68% 6.18% 5.71% 5.29% 4.89% 4.52% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 4.46% 2.23% 49
Depreciation - MACRS
Example of MACRS Depreciation:
Example:
Acquisition Cost Salvage Value Property Class $140,000 (equals initial book value) $20,000 (not used in MACRS calculation) 5 Years
Year Depreciation Percentage Depreciable Base for Calculation Depreciation Expense Cumulative Depreciation Beginning Book Value Ending Book Value
1 20.00%
2 32.00%
3 19.20%
4 11.52%
5 11.52%
6 5.76%
$140,000 $140,000 $140,000 $140,000 $140,000 $140,000 $ 28,000 $ 44,800 $ 26,880 $ 16,128 $ 16,128 $ 8,064 $ 28,000 $ 72,800 $ 99,680 $115,808 $131,936 $140,000 $140,000 $112,000 $ 67,200 $ 40,320 $ 24,192 $ 8,064 $112,000 $ 67,200 $ 40,320 $ 24,192 $ 8,064 $
*Example assumes asset is placed into service at any point in year 1.
50
First, estimate pre-tax cash flows for each year of the investment life span
Outflow (e.g. one time capital and expenses) Inflow (e.g. net annual savings)
Determine the annual depreciation on the capital investment Subtract the annual depreciation from the pre-tax cash flow to determine the taxable net income (Net Operating Profit before Taxes) Calculate the tax expense (for non-capital spending). The result is the Net Operating Profit after Taxes (NOPAT) Subtract the tax expense from the pre-tax cash flows to arrive at the after tax cash flow.
51
*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.
52
*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.
53
The higher the discount rate the lower the present value of future cash flow.
55
Do a sanity check on the assumptions and the analysis before developing a presentation.
56
MISCALCULATION
Perhaps You Will Be Long Gone Before They Realize Your Mistake
57
Project A
Project B
Project A
$300 $150 IRR=18.7%
15% 20% 25%
NPV*
Project B
NPV=$261
$150
NPV=$65
$0
5%
10%
($150)
($150)
($300) 60
Instead, a more appropriate approach is to assume positive cash flows can be reinvested at:
The average rate of return of all company investments, or The company cost of capital rate.
This will result in a more conservative and realistic expected rate of return.
61
The MIRR results in a more conservative and realistic expected rate of return
62
The MIRR results in a more conservative and realistic expected rate of return
63
$2,000 $1,000 $10,000 $9,000 $2,000 $5,000 7 Years 5 Years 7 Years 10% 40%
Marginal annual savings Marginal annual costs Inventory reduction Equipment investment Salvage value on equipment System investment with no salvage value Equipment depreciation using sum of years digits (SYD) System depreciation using sum of years digits (SYD) Cash flow horizon Discount rate Tax rate
64
$ $
2 2,000
$ $
3 2,000
4 2,000
5 2,000
6 2,000
7 2,000
8 2,000
9 2,000
10 2,000
$ $
2,000 1 1,000
$ $
2,000 2 1,000
$ $
2,000 3 1,000
$ $
2,000 4 1,000
$ $
2,000 5 1,000
$ $
2,000 6 1,000
$ $
2,000 7 1,000
$ $
2,000 8 1,000
$ $
2,000 9 1,000
$ $
2,000 10 1,000
1,000 $ 1 $ (10,000)
1,000 2
1,000 3
1,000 4
1,000 5
1,000 6
1,000 7
1,000 8
1,000 9
1,000 10
$ (10,000) $
65
$ $ $ $
$ $ $ $
$ $ $ $
$ $ $ $
$ $ $ $
$ $ $ $
$ $ $ $
$ $ $ $
$ $ $ $
$ $ $ $
10
11
66
ROI Outputs
0 Income Statement Cash Flow Marginal Savings Marginal Costs & Project Expenses Net Savings (pre Depr. & Taxes) Depreciation Expenses (non Cash) Net Operating Profit (pre-Taxes) Income Taxes Net Income (NOPAT) Cash Flow from Operations Balance Sheet Cash Flow Capital Investments (Depreciable) Change in Working Capital Cash Flow from Balance Sheet Net Cash Flow Accumulated Cash Flow Discounted Cash Flow (DCF) Accumulated DCF Net Present Value (NPV) IRR MIRR Simple Payback Period (Years) Discounted Payback Period (Years) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 1 2,000 (1,000) 1,000 (3,417) (2,417) 967 (1,450) 1,967 $ $ $ $ $ $ $ $ 2 2,000 (1,000) 1,000 (2,833) (1,833) 733 (1,100) 1,733 $ $ $ $ $ $ $ $ 3 2,000 (1,000) 1,000 (2,250) (1,250) 500 (750) 1,500 $ $ $ $ $ $ $ $ 4 2,000 (1,000) 1,000 (1,667) (667) 267 (400) 1,267 $ $ $ $ $ $ $ $ 5 2,000 (1,000) 1,000 (1,083) (83) 33 (50) 1,033 $ $ $ $ $ $ $ $ 6 2,000 (1,000) 1,000 (500) 500 (200) 300 800 $ $ $ $ $ $ $ $ 7 2,000 (1,000) 1,000 (250) 750 (300) 450 700 $ $ $ $ $ $ $ $ 8 2,000 (1,000) 1,000 1,000 (400) 600 600 $ $ $ $ $ $ $ $ 9 2,000 (1,000) 1,000 1,000 (400) 600 600 $ $ $ $ $ $ $ $ 10 2,000 (1,000) 1,000 1,000 (400) 600 600
$ (14,000) $ - $ $ (14,000) $ $ $ $ $ $ (14,000) (14,000) (14,000) (14,000) 1,756 17.6% 11.9% 2.2 3.6 $ $ $ $
$ $ $ $ $ $
$ $ $ $ $ $
$ $ $ $ $ $
$ $ $ $ $ $
$ $ $ $ $ $
$ $ $ $ $ $
$ $ $ $
$ $ $ $
$ $ $ $
67
Gross Margin
Operating Expenses (SG&A)*
50% ($400) $600 ($200) $400 20% Selling, general, and administrative costs Earnings before interest, taxes, depreciation and amortization Non Cash Expense (*often embedded in SG&A) Also referred to as EBIT
EBITDA
*Depreciation Operating Income
Operating Margin
Other Non-Operating Expenses Other Non-Operating Revenue
EBIT
Interest Expense Net Profit Before Taxes Taxes (40%) Net Income
($20) $40 $420 Earnings before interest and taxes ($50) $370 $148 $222 11%
Non-operating costs and revenues, and their proportional taxes, are excluded from NOPAT.
Profit Margin
NOPAT
$240 Net Operating Profit After Tax = Operating Income * (1-Tax Rate) 69
(1,000) $ 1,000 $
(1,000) $ 1,000 $
(1,000) $ 1,000 $
Net Savings (pre Depr. & Taxes) $ Depreciation Expenses (non Cash) $
Project Net Operating Profit After Taxes $ Cash Flow from Operations $
(772) $ 1,514 $
(1,682) $ 2,122 $
(920) $ 1,614 $
(420) $ 1,280 $
70
Example:
For simplicity, the discount rate may be used when calculating the EVA on a project investment
71
NIBCL
72
Example
Capital Expenditures (Depreciable) Equipment Systems Total Capital Investment Annual Depreciation Equipment Systems Total Depreciation Asset Book Value Equipment Systems Ending Book Value Working Capital Change in Working Capital Project Invested Capital Long Term Assets Working Capital Net Invested Capital Initial Investment $ 9,000 $ 5,000 $ 14,000 0 $ $ $ $ $ $ $ $ $ 0 9,000 5,000 14,000 0 0 14,000 14,000 $ $ $ $ $ $ $ $ $
1 1,286 1,000 2,286 1 7,714 4,000 11,714 1 (10,000) 1 11,714 (10,000) 1,714 $ $ $ $ $ $ $ $ $
2 2,204 1,600 3,804 2 5,510 2,400 7,910 2 (10,000) 2 7,910 (10,000) (2,090)
73
7 8 $ (10,000) $ (10,000) $ $ $ $ $ (10,000) $ (10,000) 7 8 $ 401 $ $ (10,000) $ (10,000) (9,599) (10,000) 7 960 118 1,078 553 $ $ $ $ 8 1,000 359 1,359 634
9 10 $ (10,000) $ (10,000) $ $ $ $ $ (10,000) $ (10,000) 9 10 $ $ $ (10,000) $ (10,000) (10,000) (10,000) 9 1,000 600 1,600 679 10 1,000 600 1,600 617
$ $ $ $ $
$ $ $ $
$ $ $ $
$ $ $ $
74
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.
75
Financial analysissummarize the results of the discounted flow assessment Critical success factorsaddress risks and mitigating actions leadership should take Project roadmapcreate a summary gantt chart of major work streams Supporting analysis and assumptions (appendices)organize in a separate file or document for easy access
76
77
Questions?
Questions
The Answer To A Good Question Can Illuminate A Room Full Of Dim Bulbs
78